The vast majority of contracts contain a clause stating that, if one of the contractual parties is declared bankrupt, the party in question incurs a penalty – in some cases a very stiff one indeed. There are also plenty of examples of contracts which stipulate that, if one of the parties is declared bankrupt after having already discharged its contractual obligations, the other party is no longer obliged to discharge its own part of the contract. Such clauses are particularly common in contracts between businesses. The question is, though: is it acceptable practice?

Freedom of contract? Yes, but subject to reasonable limits

The key principle here is that a contract is binding, irrespective of the nature of its contents. This is on condition that the terms of the contract:

  • are not against the law;
  • do not offend public decency or constitute a breach of public order (for example, they may not contravene import or export restrictions); and
  • are not so unreasonable or unfair as to be unacceptable.

A contract is also deemed to be invalid if you did not give your fully informed consent, for example, if you were deceived or made a mistake or if the other party exerted undue influence or misrepresented the terms of the contract. With the exception of these situations, the parties are free to decide on the terms of the contract for themselves.

Where the two contracting parties are legal entities, most company directors will readily accept a clause that takes effect only in the event of their company being declared bankrupt. The fact is that the directors no longer have a role to play: a receiver steps in and takes over. The company’s creditors may well suffer from such a situation, though: after all, they may well miss out on payment of a contractually agreed debt and/or they may see a rapid rise in the size of the debt.

Are you allowed to penalise a company that goes bankrupt?

In 2013, the Supreme Court of the Netherlands ruled that ‘a contractual clause that deprives a party of the right to the performance of an obligation merely as a result of the creditor’s bankruptcy or of the termination of the contract on account of the creditor’s bankruptcy, resulting in a situation in which the party that has already benefited from the other party’s performance of the contract is no longer required to perform its own part of the contract may, depending on the context and the other circumstances, be null and void.’

In short, there are circumstances in which a clause exempting a party from having to fulfil its contractual obligations merely by dint of the other party having been declared bankrupt may well be invalid.

In the summer of 2016, the Amsterdam Court of Appeal was requested to rule on the following penalty clause in a contract for the construction of the Ziggo Dome arena in Amsterdam: ‘If the contractor (...) is granted a suspension of payments or is declared bankrupt, the contractor is liable to a penalty of 8% of the contract price, which penalty is immediately due and payable.’

Surprise, surprise: the contractor went bust. The client then sought to invoke its bank guarantee for a given amount plus the value of the penalty. Although the terms of a bank guarantee generally need to be extremely precise, in this case the wording was sufficiently vague for it to be deemed to include a penalty. The receiver, on the other hand, wanted to prevent any payment from being made under the guarantee, as it would result in a flow of money covered by the guarantee to the creditors.

It was up to the Court of Appeal to decide whether the penalty clause should be triggered exclusively by the contractor’s insolvency and whether it was intended to act as an incentive for the contractor to comply with its contractual obligations. Given that this was palpably the case, the clause in question was most likely to have been illegal. This would mean that the contractor would not be liable to a penalty and hence that the client was not entitled to invoke the bank guarantee in order to collect the penalty.

The Court of Appeal ruled, however, that, in the light of the comments made by the parties about the nature of the clause, it should in fact be construed as a ‘fixed-penalty clause’. This type of clause is legal, which meant that the receiver’s case was dismissed. The Court also rejected the receiver’s claim that the client had struck a better deal with another contractor after the first contractor had gone bankrupt, and that the value of the loss actually incurred by the client was lower than the value of the penalty (irrespective of whether or not this was true).

If a ‘fixed-penalty’ clause is legal, how do you draw one up?

If one of the parties is unable to discharge its contractual obligations and if the other party suffers a loss as a result, the parties can agree that a fixed amount of damages is then payable. While such a clause is indeed lawful, payment cannot be triggered by the mere fact of bankruptcy.

In other words, the road between Scylla (i.e. an illegal penalty clause triggered by the bankruptcy of one of the parties) and Charybdis (i.e. a penalty clause couched in such broad terms as to be unacceptable to the party in question) is a narrow and tortuous.

So how can you protect your rights in the event of your contractual partner’s bankruptcy?

Feel free to get in touch with me if you wish to draw up a contract that protects your rights in the event of your contractual partner’s bankruptcy.