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Proceed With Caution! Understanding Ipso Facto Clauses In Bankruptcy

The phrase ipso facto is Latin for “by the fact itself.” Ipso facto clauses are sometimes included in lease and purchase contracts, and they assert that if the lessee or purchaser becomes insolvent, or files for bankruptcy protection, then the contract has been breached. In other words, under such a clause the very act of filing for bankruptcy protection constitutes a breach of contract that absolves the other party of any further contract obligations.

Such clauses are not valid in bankruptcy; lessors and sellers that may become creditors in a bankruptcy down the line should proceed with caution.

I.  Federal Preemption

The Bankruptcy Code was made pursuant to Congress’ Constitutional power under Article I, § 8, which provides, in pertinent part:

The Congress shall have power to establish uniform laws on the subject of bankruptcies throughout the United States.

In this regard, Article VI of the Constitution provides:

This Constitution, and the laws of the United States which shall be made in pursuance thereof shall be the supreme law of the land; and the judges in every state shall be bound thereby, anything in the Constitution or laws of any state to the contrary notwithstanding.

Because Bankruptcy Code was enacted “in pursuance” of the U.S. Constitution, it is part of the “supreme law” of the land. This means that a bankruptcy filing will trump any conflicting contract provision.

III.  The Bankruptcy Code On Ipso Facto Clauses

There are several places in the Bankruptcy Code that render ipso facto clauses null and void.

  1. Executory Contracts and Unexpired Leases

11 U.S.C. § 365 deals with executory contracts and unexpired leases. It makes provision for assuming and rejecting leases, and for curing prepetition defaults. It also states:

Paragraph (1) of this subsection [dealing with contract defaults] does not apply to a default that is a breach of a provision relating to— . . . (B) the commencement of a case under this title; . . .

11 U.S.C. § 365(b)(2)(B).

And § 365 also has the following provision (with emphasis added):

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— . . . the commencement of a case under this title.

11 U.S.C. § 365(e)(1)(B).

In other words, the commencement of a bankruptcy case does not constitute a contract default.

  1. Impairment Of Claims In Chapter 11

In a Chapter 11 bankruptcy case an impaired claim typically receives different treatment than an unimpaired claim. An impaired claim is one in which the claimant will be treated differently from the way it would have been treated under the terms of the prepetition contract underlying the claim. In 11 U.S.C. § 1124, the filing of a bankruptcy case does not constitute an impairment of a claim:

Except as provided in section 1123(a)(4) of this title, a class of claims or interests is impaired under a plan unless . . . the plan . . . notwithstanding any contractual provision or applicable law . . . — . . . cures any such default that occurred before or after the commencement of the case under this title, other than a default of a kind specified in section 365(b)(2) of this title . . .

11 U.S.C. § 1124(2)(A)

Thus, the filing of a bankruptcy does not impair a creditor’s prepetition contractual right, and an ipso facto clause cannot change that fact.

  1. Estate Assets

Finally, 11 U.S.C. § 541(c) provides that an ipso facto clause cannot change the nature of the debtor’s assets that become property of the bankruptcy estate upon the filing:

An interest of the debtor in property becomes property of the estate under subsection (a)(1), (a)(2), or (a)(5) of this section notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law — . . . that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.

In sum, ipso facto clauses are generally unenforceable in bankruptcy.

III.  How to Limit Risk from a Creditor’s Perspective

There are means for a creditor to better control its fate in the event that a bankruptcy is filed. One such way is to remove all of the debtor’s legal and equitable title to the collateral subject to the contract by way of escrow accounts, trusts and other legal instruments. By eliminating title, the protections of the Automatic Stay will not apply, as the Stay only applies to property of the estate.

Thus, a creative and pro-active creditor can take measures in advance of a bankruptcy filing to protect its interests in collateral. Its advisable to explore these mechanisms early in a commercial relationship, when presumably: (1) the lessee/purchaser’s financial condition is at its most favorable; (2) due diligence investigation into the lessee/purchaser’s assets are being undertaken and (3) there would be the least resistance to the idea.

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