{"id":54,"date":"2013-12-09T14:01:50","date_gmt":"2013-12-09T20:01:50","guid":{"rendered":"http:\/\/ericlambert.net\/blog\/?p=54"},"modified":"2013-12-09T14:01:50","modified_gmt":"2013-12-09T20:01:50","slug":"whats-the-point-of-a-termination-on-bankruptcy-or-insolvency-clause","status":"publish","type":"post","link":"https:\/\/ericlambert.net\/blog\/2013\/12\/09\/whats-the-point-of-a-termination-on-bankruptcy-or-insolvency-clause\/","title":{"rendered":"What\u2019s the Point of a \u201cTermination on Bankruptcy or Insolvency\u201d Clause?"},"content":{"rendered":"

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.\u00a0 This type of clause is commonly known as an ipso facto <\/i>clause.\u00a0 Ipso facto <\/i>is Latin for \u201cby the fact itself,\u201d and means that the occurrence of something is a direct consequence and effect of the action in question.\u00a0 The action is the bankruptcy or insolvency of Party A, and the occurrence is the right to terminate by Party B.\u00a0 This clause is considered \u201cboilerplate\u201d in most contracts, and is rarely negotiated (or even discussed). \u00a0However, attorneys and business persons alike should be very careful in relying on the right to terminate in this clause, as it\u2019s generally unenforceable<\/span>.<\/p>\n

State law generally governs whether a contract is enforceable or non-enforceable.\u00a0 However, one very big exception to that rule is the federal law governing bankruptcies (Title 11 of the United States Code, known as the \u201cBankruptcy Code\u201d).\u00a0 One of the primary goals of federal bankruptcy law is to allow a debtor to reorganize their business.\u00a0 In order to do that, the Bankruptcy Code overrides state enforcement of ipso facto <\/i>clauses and invalidates them (in most cases) as a matter of federal law.\u00a0 Section 365(e)(1) of the Bankruptcy Code states that an \u201cexecutory contract\u201d (i.e., a contract where there\u2019s 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.\u00a0 In other words, you generally can\u2019t exercise an ipso facto <\/i>clause under federal bankruptcy law once a bankruptcy starts, no matter what the contract says.\u00a0 (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\u2019t be terminated by an ipso facto <\/i>clause.)\u00a0 Once bankruptcy starts and while it\u2019s underway, only the trustee of the debtor can assume or reject an executory contract \u2013 it\u2019s out of your hands.<\/p>\n

Ipso facto <\/i>clauses have remained in agreements through the years even though they\u2019re no longer very useful, like a contract\u2019s version of a human appendix.\u00a0 There\u2019s actually a few good reasons to keep them around.\u00a0 It\u2019s important to remember that the clause\u2019s 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.\u00a0 (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 \u201cpreference payment.\u201d)\u00a0 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\u2019t consent to the assumption or assignment, e.g., the debtor is was commissioned to paint a mural based on his expertise \u2013 the building owner doesn\u2019t have to accept the trustee\u2019s paint job as a substitute.\u00a0 Finally, it\u2019s always possible the Bankruptcy Code could be changed in the future to allow for the enforcement of ipso facto <\/i>clauses under state law, perhaps through an expansion of the exceptions under Section 365(e)(2).<\/p>\n","protected":false},"excerpt":{"rendered":"

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 … Continue reading →<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[14,4,9,1],"tags":[],"class_list":["post-54","post","type-post","status-publish","format-standard","hentry","category-drafting","category-legal","category-otherlegal","category-uncategorized"],"_links":{"self":[{"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/posts\/54","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/comments?post=54"}],"version-history":[{"count":0,"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/posts\/54\/revisions"}],"wp:attachment":[{"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/media?parent=54"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/categories?post=54"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/ericlambert.net\/blog\/wp-json\/wp\/v2\/tags?post=54"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}