Enforceability of Ipso Facto Clauses in Bankruptcy

Most lease and purchase contracts include a termination-on-bankruptcy (ToB) provision. Usually referred to as an ipso facto clause, the term generally states that either party may terminate an agreement without notice if the other party files for bankruptcy or becomes insolvent. In other words, a bankruptcy is considered a breach of contract and absolves the other party of any further contractual obligations.

Below is a sample of an ipso facto clause you might see in a contract:

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.

While most contracts contain an ipso facto clause, can they easily be enforced to terminate an agreement?The short answer is NO.

Provisions of the Bankruptcy Code

Due to a couple of sections of the Bankruptcy Code, ipso facto provisions dealing with bankruptcy or insolvency are generally not enforceable. Let’s take a closer look at each one of the two provisions:

1. Section 541(c) states any interest in property becomes the property of the bankruptcy estate. All property and contracts are then placed under the jurisdiction of a bankruptcy court that then hires a bankruptcy trustee. Only the bankruptcy court can decide on a termination, regardless of what the ipso facto clause says.
2. Section 365 (e)(1) invalidates any ipso facto clause that might result in the forfeiture of an executory (a contract in which terms are set to be fulfilled at a later date) or unexpired lease contract.

In a nutshell, these two bankruptcy laws prevent an ipso facto clause from taking effect unless a bankruptcy court gives the creditor permission to continue with a contract termination or until a bankruptcy is closed. Without a strong reason, requests for termination are usually denied.

Why Do Ipso Facto Clauses Exist?

Why are ipso facto clauses included in contracts if they are not enforceable? There are several reasons for this:

1. Habit: Before 1979, ipso facto clauses were enforceable but the Bankruptcy Code changed that. Lawyers got accustomed to including the clause in their contracts and they continued the habit. Lawyers also believe it’s possible the Bankruptcy Code may be changed to make ipso facto clauses enforceable in the future.
2. Actual Bankruptcy: It’s necessary to note that an ipso facto clause only applies if bankruptcy is filed. If an ipso facto provision states that an agreement can be terminated because of insolvency, and no bankruptcy case is ever filed, the solvent party could terminate the agreement. If a bankruptcy is filed at a later time, an insolvency-based termination may not be enforced, giving the debtor the chance to retain their rights under the contract.
3. Section 365(e)(2): This code, in conjunction with Section 365 (e)(1), provides that an ipso facto clause can be enforceable if the debtor or trustee is not permitted by applicable law to assume or assign the executory contract.

If you are involved in a contract that involves an ipso facto clause, contact our Chicago bankruptcy attorneys at Atlas Consumer Law immediately. Enlist our help today and we’ll provide aggressive and passionate representation for matters such as bankruptcy, foreclosure, creditor harassment and foreclosure. Our firm has secured millions of dollars in recovery for our clients across Illinois.