Practically all commercial transactions, including licenses, services agreements, and supply agreements, contain a provision that triggers termination rights, without notice, to a party whenever the other party files for bankruptcy or experiences other insolvency-related event. In Part 1 of a two-part series, we discuss how the commonly used termination-on-insolvency clauses are generally unenforceable despite their widespread use.
Standard Ipso Facto Provision
Termination in the event of bankruptcy or insolvency clauses (commonly called “ipso facto” clauses) are often included in contracts and are rarely a point of contention in contract negotiations. A sample of a typical ipso facto clause you might see in a contract is as follows:
This Agreement shall terminate, without notice, (i) upon the institution by or against either party of insolvency, receivership or bankruptcy proceedings or any other proceedings for the settlement of either party's debts, (ii) upon either party making an assignment for the benefit of creditors, or (iii) upon either party's dissolution or ceasing to do business.
The intent of ipso facto clauses is to provide a mechanism for a party to terminate an agreement whenever insolvency becomes a risk in that the insolvent party would not be able to perform their contractual obligations. It may surprise some, however, to find out that although these types of clauses are common and logical, they are generally not enforceable in a bankruptcy proceeding.
Bankruptcy Code Restrictions
Once a bankruptcy is filed, the court has broad authority over a debtor’s (the bankrupt company or person) property. As such, the Bankruptcy Code supersedes contracted ipso facto clauses, rendering them generally unenforceable based on two code provisions.
First, Sections 541(a) and (c) of the Bankruptcy Code provide that an interest of the debtor in property becomes property of the bankruptcy estate. This means that the court controls all property and contracts of the debtor and only the court can decide whether a contract can be assumed, rejected, or otherwise terminated despite what is stated in the contract.
Second, Section 365(e)(1) addresses ipso facto clauses in executory contracts, which are contracts that have not yet been fully performed or fully executed. Section 365(e)(1) specifically states that notwithstanding a provision in an executory contract, a debtor’s executory contract cannot be terminated or modified after the bankruptcy case has been filed solely because a term of the contract is conditioned on insolvency or financial condition of the debtor prior to the filing of bankruptcy. This provision of the Bankruptcy Code generally makes ipso facto clauses for executory contracts unenforceable.
When read in combination, these bankruptcy statutes invalidate ipso facto clauses unless a bankruptcy court approves the contract termination or until the bankruptcy proceedings are finalized.
In Part 2, we will discuss the key exceptions to the general proposition that ipso facto clauses are unenforceable and why these clauses are still commonplace in commercial agreements.