In Part 1, we discussed how, despite widespread usage, termination in the event of bankruptcy clauses (“ipso facto” clauses) are generally unenforceable pursuant to the bankruptcy code. In this second part, we discuss why these clauses are still prevalent in commercial transactions and the exceptions that allow for enforceability in certain situations.
Why Do Ipso Facto Clauses Remain in Most Contracts?
If ipso facto clauses are generally not enforceable, then why do practically all commercial agreements continue to include them? There are several reasons.
- History. Up until the Bankruptcy Code was codified in 1979, ipso facto clauses were enforceable without question. It became habit for businesses and attorneys to expect ipso facto clauses in their commercial agreement templates and this practice has continued. Some believe that in the future the Bankruptcy Code could be changed to reinstate the enforceability of ipso facto clauses so lawyers often see little reason to cease the practice of including them in their agreements.
- Actual Bankruptcy Required. Another reason is the important distinction between insolvency and bankruptcy. The Bankruptcy Code’s rules against enforceability of an ipso facto clause would only apply if a bankruptcy case is actually filed. If an ipso facto provision provides that the agreement terminates upon a party’s insolvency, (as stated in the sample ipso facto clause in Part 1) and no bankruptcy case is ever filed (or if it is filed and then dismissed under section 1112 of the Bankruptcy Code, for instance), then a party would be able to rely on the ipso facto clause to terminate the agreement. It must be noted, however, that if the terminated party later files a bankruptcy, then the bankruptcy court could potentially invalidate the pre-bankruptcy filing termination.
- Personal Services Exception. Section 365(e)(2) of the Bankruptcy Code, in conjunction with Section 365(c)(1), provides that ipso facto clauses are enforceable if applicable law excuses a party from accepting performance from, or rendering performance to, the trustee or to an assignee of such contract or lease unless the party agrees otherwise. Simply, put if applicable law states that an IP license, for example, cannot be assigned without the other party’s consent the non-debtor party can seek to enforce the ipso facto clause. The most common type of contract falling into this exception is a contract for unique personal services by a person with special knowledge, judgment, taste, skill, or ability (commonly referred to as the “personal services” exception) where the promised performance by debtor is so distinctive that it would not be reasonable to expect another to perform. For example, if the debtor were a noted singer.
- Other Exceptions. Lastly, the safe harbor provisions in the Bankruptcy Code at Sections 555, 556, 559, 560, and 561 allow for enforcement of ipso facto provisions in specified securities and financial market transactions.
Parties continue to include ipso facto provisions in contracts, even though bankruptcy courts have generally made them unenforceable. The fact is, many businesses include these provisions, thinking that they are protecting themselves in case of an insolvency event of the other party without realizing that these provisions may be ineffective. If enforcing an ipso facto clause arises, one may need to explore alternative approaches to mitigate risks.