Bankruptcy Basics for New and Non-Bankruptcy Attorneys

This entry is part of Nelson Mullins’s ongoing “Bankruptcy Basics” blog series that is intended to address foundational aspects of bankruptcy for non-bankruptcy practitioners and professionals.  This entry will discuss how ipso facto clauses are treated in bankruptcy.

Imagine you are the vendor to an entity that has just filed for protection under chapter 11 of the Bankruptcy Code.  Your contract documents include the following default provision:

Termination for Bankruptcy. This Agreement may be terminated at any time during the Term by either Party upon the other Party’s filing or institution of bankruptcy, reorganization, liquidation or receivership proceedings, or upon an assignment of a substantial portion of the assets for the benefit of creditors by the other Party.

Based on this provision, you presume you have the ability to terminate the Agreement, right?  Wrong. 

Why, you might ask, can you not terminate despite the clear terms of the contract?  Bankruptcy Code section 365(e)(1) is the answer, which reads:

Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title; or

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

Under this section, many of these types of contract provisions, referred to as ipso facto clauses, are unenforceable.  The policy behind the invalidation of these provisions is two-fold: (1) to prevent creditors from obtaining an unfair advantage over debtors by contracting around bankruptcy prepetition and (2) to prevent creditors from obtaining an improper preferred position to other equally situated creditors. 

Despite the relative unenforceability of these provisions, contracts are replete with these provisions.  To that end, knowledge of the fact that these provisions are generally toothless can provide you with negotiating leverage, if the other side is unaware of this fact.  This is an easy “give” in negotiations, as it does not actually “give” anything away. 

So if you’re in a situation where you or a client is facing a bankrupt contract counter-party, don’t bank on any ipso facto clauses bailing you out.