Anticipating defaults under existing contracts
In our first alert in the present series, we considered practical steps that can be taken now to anticipate and prepare for potential counterparty defaults under existing contracts. These include:
- Identifying and collating key contractual documents in one place;
- Identifying, where possible, common provisions running across existing contracts that may offer assistance – for example, contractual rights to seek performance assurance, credit support, and so forth;
- Identifying the necessary tests and notice requirements for invoking such provisions; and
- Maintaining discipline around communications with counterparties across different internal functions to avoid the risk of an inadvertent waiver of contractual rights.
Negotiating and drafting commercial contracts to anticipate potential counterparty defaults
When it comes to the negotiation of new contracts, a number of steps can be taken contractually to anticipate potential adverse changes in a counterparty’s creditworthiness, breaches of contract, or actual insolvency. In this alert, we consider best practices in the drafting of such contractual provisions, focusing on (1) material adverse change clauses, (2) contractual rights of termination, and (3) specific insolvency-related provisions.
A. Material adverse change clauses
Material adverse change (MAC) clauses give one party specific rights upon the occurrence of events which have impaired or may impair the counterparty’s ability to perform the contract. MAC clauses may therefore be used to allow protective steps to be taken where a potential insolvency-related default by a counterparty is anticipated, but before it has occurred, such as suspending deliveries or requiring the counterparty to provide additional credit or performance assurance. Having such rights is particularly important where credit is extended to the counterparty. As a matter of English common law, in the absence of an express MAC clause in the parties’ contract, there may be little or nothing that can be done prior to the counterparty’s actual default to minimise exposure to the counterparty. A number of considerations arise when drafting MAC clauses.
Defining the trigger: It is important to define adequately what events or circumstances would need to occur in order to be able to rely on the MAC clause. The trigger for MAC may be objectively determinable by reference to the counterparty’s financial position, such as failing to maintain a specific credit rating or financial metric. This approach gives both parties the benefit of increased certainty as to whether the MAC has arisen, but gives the MAC a narrow scope.
A more common approach to the trigger is the more subjective approach where, in the relying party’s opinion, the counterparty’s ability to perform its obligations under the contract has been materially impaired. This allows the party invoking the clause to take into consideration all external and internal issues that might affect the counterparty’s creditworthiness, and may provide grounds for invoking the clause in response to any general market turmoil caused by COVID-19. However, in order to counterbalance such wide discretion, counterparties may insist that the relying party’s belief that a MAC has occurred must be reasonably held. Even where a ‘reasonableness’ qualification is not included expressly, the relying party’s discretion to invoke the MAC clause will not be completely unfettered, and it will still be necessary for the relying party to demonstrate that its opinion was genuinely held, honest, and rational.1
Materiality: By definition, a MAC event should be material. Consideration of materiality may include durational significance, and short-term disruptions or difficulties caused by COVID-19 and its effects may not be enough to trigger the MAC clause.
Change: Since MAC clauses require there to have been some ‘change’, a party will typically not be entitled to rely on the MAC on the basis of circumstances which already existed when the parties entered into the agreement. This will be of special importance to new contracts entered into after the COVID-19 outbreak started. However, parties should in principle still be able to rely on MAC clauses where COVID-19 has an unexpectedly serious effect on the counterparty, beyond what the parties might reasonably have expected at the point of contracting.
Defining the effects of MAC: MAC clauses will provide for specific rights if they are triggered. These may include, where the party invoking the clause is the seller, the right to demand additional credit support for the unpaid price of the goods. A MAC clause may also include more generally a right for either party to demand ‘performance assurance’ from the counterparty affected by MAC. Under English law, at least, there is no general right to demand security or performance assurance even where there are real grounds to suspect the counterparty may not be able to perform the contract, although other jurisdiction’s laws may take different approaches.2
Credit support and performance assurance can take the form of cash prepayment, standby letters of credit, on demand guarantees, documentary letters of credit, bank guarantees, and parent company guarantees. When drafting MAC clauses, it will be important to consider which party chooses the form of the performance assurance – cash prepayment and instruments that are easily called upon (for example, standby letters of credit and on-demand guarantees) could result in the counterparty being exposed to significant credit risk on the relying party itself.
Rights of suspension and termination: Where the demanded credit support or performance assurance is not provided, a MAC clause may allow a right to suspend performance and may constitute an event of default giving rise to a right to terminate the agreement.
Practical considerations when asserting MAC: The party seeking to rely on the MAC clause has the burden of proving that the MAC has arisen. An unjustified invocation of the MAC clause may itself be a repudiatory breach of the contract by the relying party, so it will be vital for the relying party to gather all available evidence of the MAC to support its position in any future dispute under the contract. MAC clauses will often include specific notice requirements with which it will be important to comply.
B. Events of default and termination clauses
As a matter of common law, not every breach of contract will entitle the non-defaulting party to terminate the contract, and certain events which may have serious ramifications for performance, such as insolvency-related events with respect to the counterparty, may not even be breaches of the contract at all. For these reasons, it is good practice to include in commercial contracts termination clauses that specify particular events of default with respect to the contract and that provide the parties with rights of termination, either with immediate effect or after the relevant event of default (if capable of cure) has not been cured within a specified period. Such contractual rights of termination may be agreed to be in addition to or in lieu of common law rights of termination, although the presumption is that common law rights of termination will be preserved unless the contract clearly provides otherwise.3
Examples of specific instances where rights of termination may arise include:
Material or persistent breach: The phrase ‘material breach’, although common, can raise as many question as it answers, and it is advisable where possible to specify what particular breaches would be sufficiently ‘material’ to justify termination of the contract. For example, a supplier’s or customer’s failure to deliver or take delivery of a specific quantity of goods over a specific period could be a (nonexhaustive) example of a ‘material’ breach. Such a right is also important in ‘term’ or instalment supply contracts where at common law, breaches with respect to individual shipments are treated as ‘severable’ and so may not permit termination of the contract as a whole.
Non-payment: It is often advisable to specify that failure to make payment on time will constitute an event of default that gives rise to a right of termination, for example after failure to remedy such a breach within a specified period. This is particularly important for sellers of goods under instalment contracts, because unless a different intention appears from the terms of the contract, stipulations as to time of payment are not of the essence of a contract of sale.4 Absent such a contractual right, a seller may well be obliged to continue to deliver future shipments even where the buyer has failed to make payment for a single shipment.
Cross-default: A termination clause is also an opportunity to agree on cross-default provisions with respect to other contracts, for example across a suite of related agreements or the parties’ wider relationship. This can be of particular benefit in an insolvency situation with respect to a counterparty and can also be combined with netting provisions. Absent such a contractual term, the position under each contract must be considered individually and on its own terms.
Other breaches: Rights of termination can also be provided for with respect to other significant breaches of the contract, such as unauthorised change of control, breaches of anti-corruption provisions, and violation of sanctions. Such rights may well not exist at common law.
Consequences of termination: A termination clause may specify the particular financial consequences of termination, which could be identical to common law damages for repudiatory breach (and it is good practice to specify this where applicable), but could provide for payment of some other amount. Termination clauses that are silent as to the consequences of termination upon an event of default may give rise to uncertainty as to what amount, if any, the parties intended would be payable upon termination pursuant to the clause.5 A termination clause can also allow the non-defaulting party a right to suspend its performance - which is a right that does not exist at common law - where the non-defaulting party who is entitled to terminate has to elect between keeping the contract alive (affirmation) and terminating the contract.
C. Insolvency clauses
Insolvency-related events of default clauses may allow rights of termination upon a counterparty’s insolvency that are unlikely to exist at common law. However, contractual rights of termination upon a counterparty’s insolvency are not without their pitfalls and require careful drafting.
Recognition: The key risk to the effectiveness of insolvency-related events of default is a question of whether they will be recognised in the relevant jurisdiction of the counterparty’s insolvency. The jurisdiction in which a counterparty is incorporated may place a general prohibition on the reliance on such provisions, known as ipso facto provisions. For example, insolvency-related events of default are typically of no effect against U.S. and Singaporean counterparties and may only be relied on in certain contracts with counterparties in Australia and other jurisdictions. Even in England, which has historically emphasised freedom of contract, the application of ipso facto clauses is currently under review following a government announcement in August 2018.
Against this background, suppliers of goods and creditors should try to ensure that contracts contain representations as to the ‘Centre of Main Interest’ (COMI) of the counterparty and an undertaking that the counterparty will not move its COMI. The COMI of a company, meaning in broad terms the place from where the business is managed and operated, will likely determine the jurisdiction where the company would enter insolvency.
Drafting insolvency provisions: Insolvency-related events of default clauses are typically split into two categories: those triggered by a deterioration in the financial position of the company, or a ‘state of insolvency’, and those triggered by the commencement of formal insolvency or restructuring proceedings, or ‘actual insolvency’.
Test for ‘state of insolvency’: Under English law, the test of insolvency is determined by reference to whether a company is deemed unable to pay its debts (typically measured on a cash flow basis, ( an ability to pay debts as they fall due) and by a balance sheet test (where the value of a company’s assets is less than its liabilities, taking into account contingent and prospective liabilities). When drafting insolvency-related events of default clauses, sellers of goods and creditors should make sure that the ‘state of insolvency’” test is easily measureable so that it is clear whether the rights under the clause can be invoked. Where a statutory test for insolvency is referred to, it may need to be tailored to fit into the contractual setting (for example, the English test of insolvency requires insolvency to be “proven to the satisfaction of the court”, which is not appropriate for an insolvency test in a contract).
Insolvency proceedings: It is also important to draft as widely as possible to capture the various types of insolvency regimes that might apply in various jurisdictions. When listing the insolvency-related processes that might apply, it is sensible to include “any analogous proceeding in any jurisdiction” language at the end of such provisions, as insolvency processes vary from jurisdiction to jurisdiction. The provisions should also include “any procedure or step in relation to” the various insolvency proceedings and should capture scenarios where any enforcement steps are taken in any jurisdictions against the counterparty so as to create a trigger at the earliest point in time.
Solvent arrangements with creditors: In the current climate, counterparties who encounter financial difficulties may enter into discussions with creditors with a view to achieving a restructuring. Insolvency events of default may therefore also contain a trigger where a counterparty in financial difficulties commences negotiations with creditors with a view to rescheduling its debts.
Frivolous or vexatious actions: Insolvency-related events of default often contain a caveat that an event of default is not triggered on a winding-up petition that is frivolous or vexatious and that is dismissed within a certain period from commencement. It is important that this time frame remains limited, as winding-up petitions - even where frivolous or vexatious - can be an indicator that a company is in financial distress and may have other knock-on effects. For example, in England, where a winding-up petition has been presented, transactions entered into by a company can be void without the validation of the court. It is also common for banks to freeze bank accounts as soon as a winding-up petition is presented. Clearly, having contractual termination rights in this scenario is of value, at the very least as the basis for discussions with the counterparty.
Insolvency of affiliates: Consideration should be given to whether an event of default should arise only upon the insolvency of the contractual counterparty or also upon the insolvency of other companies in its group (for example, where the insolvency of a parent or other key company within the group is likely to have a knock-on effect on the contracting counterparty).
Practical steps: Legal advice should always be taken before invoking an insolvency-related event of default. A declaration of an event of default can have serious ramifications for a counterparty, not only under the relevant contract but also because it could precipitate insolvency and trigger cross-defaults across a group.
It is also advisable to seek local law advice in respect of the jurisdiction in which your counterparty is incorporated, in addition to legal advice under the applicable law of the contract. Legislative changes to local insolvency rules can apply retrospectively, so advice received at the time of entering into a contract may not necessarily be applicable at the time you consider exercising your rights.
D. Conclusions
Parties may significantly enhance their ability to anticipate and respond to potential and actual counterparty defaults by careful drafting. The invocation of such rights requires particular care, and legal advice should be taken on the specific contract terms and all relevant laws.
- See Cukurova Finance International Ltd v. Alfa Telecom Turkey Ltd [2013] UKPC 2.
- For example, in the United States, under section 2-609 of the Uniform Commercial Code, either party to a contract of sale has the right to demand “adequate assurance of due performance” where “reasonable grounds for insecurity arise” with respect to the counterparty’s performance.
- Gilbert-Ash (Northern) Ltd v. Modern Engineering (Bristol) Ltd [1974] AC 689.
- Sale of Goods Act 1979, section 10(1).
- See, for example, Stocznia Gdynia SA v. Gearbulk Holdings Ltd [2009] EWCA Civ 75).
Client Alert 2020-143
