|November 21, 2011|
Previously published on November 2011
Contracts and leases typically contain a provision, called an “ipso facto clause,” which states that the filing of a bankruptcy case or the occurrence of another listed event is a default entitling the other party to terminate the agreement and to begin exercising remedies. The term “ipso facto” comes from the Latin phrase meaning “by the fact itself.” Thus, the filing of the bankruptcy or other action itself triggers the default. Some ipso facto clauses require notice first; others are automatic.
A. Triggers for Ipso Facto Clauses
Typical ipso facto clauses are based on the following events:
Filing of a voluntary bankruptcy petition
Having an involuntary bankruptcy filed against a party (sometimes, if the petition is not set aside within a set number of days)
Insolvency or financial condition
Admitting in writing that a party is insolvent
The making of an assignment for the benefit of creditors or the appointment of a receiver for all or a substantial portion of a party’s assets.
B. Ipso Facto Clauses Are Generally Not Enforceable in Bankruptcy Cases
Section 541 of the Bankruptcy Code sets forth what interests in property become property of the bankruptcy estate. Section 541(c) provides that property interests of the debtor become property of the bankruptcy estate notwithstanding a provision in an agreement that requires forfeiture of the interest based on the insolvency or financial condition of the debtor, the commencement of the case, or the appointment of a custodian before the commencement of the case.
Section 365(e)(1) of the Bankruptcy Code expressly invalidates ipso facto clauses that might otherwise result in forfeiture of an executory contract or an unexpired lease. Section 365(e)(2) of the Bankruptcy Code provides that the invalidation of ipso facto clauses does not apply to contracts that are non-assignable under applicable non-bankruptcy law or to contracts to make a loan or extend financial accommodations or debt financing to or for the benefit of the debtor.
Provisions in unexpired leases for real property containing ipso facto clauses would be invalided as to a debtor under the Bankruptcy Code. Section 365(f) of the Bankruptcy Code states that notwithstanding language in an executory contract or lease to the contrary, the trustee (or debtor-in-possession) may assume a contract or lease provided the trustee (or debtor-in-possession) furnishes adequate assurances of future performance and cures all defaults as required under §365(b) of the Bankruptcy Code.
C. Why Put Ipso Facto Clauses in Agreements?
Ipso facto clauses typically are only unenforceable in a bankruptcy. If the party never files a bankruptcy, then the clause may be enforceable. However, if a later bankruptcy is filed, an insolvency-based termination made prior to the bankruptcy may not be enforceable in the later bankruptcy case.
Further, an ipso facto clause may trigger a default under a guaranty of a non-bankrupt guarantor or liability of a co-debtor that does not file a bankruptcy petition.
Although an ipso facto clause may not be enforceable in bankruptcy, these clauses are commonplace and will not prejudice the landlord. If a commercial tenant is a debtor in a bankruptcy case, it is required under §365(d)(4) of the Bankruptcy Code to assume the lease (which means the debtor will need to cure defaults and provide adequate assurances of future performance) within the earlier of 120 days from the commencement of the case, or the entry of the order confirming the plan. Without the landlord’s consent, at most the bankruptcy court can extend this period for 90 days for cause. If the lease is either rejected by the trustee (or debtor-in-possession) or not assumed in these time periods, the lease is considered to be rejected and the debtor is required to immediately surrender the property to the landlord. Accordingly, notwithstanding the unenforceability of ipso facto clauses in commercial real property leases, a commercial landlord is not without remedies in the bankruptcy arena.