What’s the Point of a “Termination on Bankruptcy or Insolvency” Clause?

Almost every contract drafted today contains a clause allowing for a party to terminate the agreement if the other party files for bankruptcy, is forced into bankruptcy by a third party (involuntary bankruptcy), makes an assignment for the benefit of creditors, becomes or admits to being insolvent or generally unable to pay its debts when due, breaches a covenant related to financial condition, ceases to do business, etc.  This type of clause is commonly known as an ipso factoclause.  Ipso factois Latin for “by the fact itself,” and means that the occurrence of something is a direct consequence and effect of the action in question.  The action is the bankruptcy or insolvency of Party A, and the occurrence is the right to terminate by Party B.  This clause is considered “boilerplate” in most contracts, and is rarely negotiated (or even discussed).  However, attorneys and business persons alike should be very careful in relying on the right to terminate in this clause, as it’s generally unenforceable.

State law generally governs whether a contract is enforceable or non-enforceable.  However, one very big exception to that rule is the federal law governing bankruptcies (Title 11 of the United States Code, known as the “Bankruptcy Code”).  One of the primary goals of federal bankruptcy law is to allow a debtor to reorganize their business.  In order to do that, the Bankruptcy Code overrides state enforcement of ipso factoclauses and invalidates them (in most cases) as a matter of federal law.  Section 365(e)(1) of the Bankruptcy Code states that an “executory contract” (i.e., a contract where there’s still performance obligations outstanding) may not be terminated following commencement of bankruptcy solely because of a termination right based on the insolvency or financial condition of the debtor at any time before the closing of the bankruptcy.  In other words, you generally can’t exercise an ipso factoclause under federal bankruptcy law once a bankruptcy starts, no matter what the contract says.  (Another clause, Section 541(c), states that a property interest becomes property of the estate upon commencement of bankruptcy, meaning that the property interest can’t be terminated by an ipso factoclause.)  Once bankruptcy starts and while it’s underway, only the trustee of the debtor can assume or reject an executory contract – it’s out of your hands.

Ipso factoclauses have remained in agreements through the years even though they’re no longer very useful, like a contract’s version of a human appendix.  There’s actually a few good reasons to keep them around.  It’s important to remember that the clause’s unenforceability under federal law is tied to the actual commencement of bankruptcy; if that never happens, the clause is still enforceable, or at least potentially usable as a saber that can be rattled.  (Keep in mind that if you terminate under the clause and then bankruptcy is filed, the debtor may try to petition the court to reinstate the agreement and rescind the termination, similar to a “preference payment.”)  There are also a couple of limited exceptions under Section 365(e)(2) of the Bankruptcy Code, such as where applicable law excuses the other party from accepting performance (whether or not the contract prohibits or restricts the assignment or delegation), and that party doesn’t consent to the assumption or assignment, e.g., the debtor is was commissioned to paint a mural based on his expertise – the building owner doesn’t have to accept the trustee’s paint job as a substitute.  Finally, it’s always possible the Bankruptcy Code could be changed in the future to allow for the enforcement of ipso factoclauses under state law, perhaps through an expansion of the exceptions under Section 365(e)(2).