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Ipso Facto Clauses and Reality I Dont Care What the Documents Provide

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When creditors are parties to a bankruptcy proceeding, they often assert that (a) the bankruptcy filing was an event of default, and (b) that the automatic stay was waived by various provisions in the agreement. Such provisions are common as the creditor wishes to avoid the consequences and effects of a bankruptcy proceeding.

During a bankruptcy proceeding, however, enforcing such provisions is not as common due to the Bankruptcy Code's underlying public policy, which does not support the avoidance of rights under the Code by prior agreement. Although creditors continue in their efforts to find means to avoid a bankruptcy proceeding, such efforts may be in vain. Nonetheless, attempts are made through agreements regarding bankruptcy and the automatic stay, otherwise known as ipso facto clauses, to alter those rights. In reality, these clauses and/or agreements are not the saving grace that one might think.

Ipso Facto Clauses

An ipso facto clause is a provision that declares a default in the event of insolvency or bankruptcy, or would otherwise affect and/or waive the rights of a debtor in bankruptcy, such as the protections afforded by the automatic stay. However, some courts have found such agreements unenforceable. In re Atrium Highpoint Ltd. Partnership, 189 B.R. 599 (Bankr. M.D. Fla. 1985); In re Madison, 184 B.R. 686 (Bankr. E.D. Pa. 1995); Matter of Pease, 195 B.R. 431 (Bankr. D. Neb. 1996); In re South East Financial Associates Inc., 212 B.R. 1003 (Bankr. M.D. Fla. 1997).

Perhaps the best explanation of why ipso facto clauses are not always enforced is an examination of legal fictions. Specifically, incorporation creates a legal fiction: the corporation. Similarly, filing a bankruptcy petition creates an additional legal fiction: the bankruptcy estate. As separate legal entities, a debtor's acts do not necessarily bind that debtor's bankruptcy estate, which is undoubtedly contingent upon the ruling of the bankruptcy court. In re Darrell Creek Associates L.P., 187 B.R. 908 (Bankr. D. S.C. 1995).


Despite the creative methods developed to alter rights under the Bankruptcy Code, the bankruptcy court has the ultimate power to determine the validity and enforceability of these provisions and acts.

Indeed, Congress foresaw such agreements and addressed their enforceability in the Code. 11 U.S.C. §365(e)(1). Specifically, §365(e)(1) states:

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—
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
Collier on Bankruptcy expounds upon §365(e)(1) by stating that:
[s]ection 365(e) expressly invalidates ipso facto and other bankruptcy termination clauses that might otherwise prevent the estate from receiving the benefit of an executory contract or lease. Under §365(e), a clause providing for the termination or modification of an executory contract or lease conditioned on the debtor's insolvency or financial condition, the commencement of a bankruptcy case or the appointment of a receiver or custodian, is inoperative in a bankruptcy case. Section 365(e) has also been held to preempt contrary provisions of state law which purport to release the non-debtor from a contract upon bankruptcy filing. Consequently, the trustee or debtor-in-possession may assume such a contract or lease notwithstanding a clause triggered by these events.

The broad language of §365(e) is intended to address provisions in contracts or leases that lead to the same effect as a clause triggered by bankruptcy, without mentioning bankruptcy. Thus, a provision conditioned on the debtor's insolvency or financial condition, or on the appointment of a trustee or receiver, is invalid because it is most likely to operate in the vicinity of a bankruptcy case.

3 Collier on Bankruptcy ¶365.07 (15th ed. 2000) (footnotes omitted); see, also, In re Metrobility Optical Sys. Inc., 268 B.R. 326, 329 (Bankr. D. N.H. 2001) ("§365(e) invalidates ipso facto clauses in executory contracts and unexpired leases."); In re National Hydro-Vac Indus. Serv. L.L.C., 262 B.R. 781, 786 (Bankr. E.D. Ark. 2001) ("That section [365(e)(1)] 'expressly invalidates ipso facto and other bankruptcy termination clauses' predicated on the debtor's financial condition, the debtor's bankruptcy filing or the appointment of a trustee in bankruptcy."); In re Pak, 252 B.R. 215, 217 n.1 (Bankr. M.D. Fla. 2000) ("A creditor cannot force a default upon a debtor by the use of the ipso facto clause of a contract solely because of a bankruptcy filing.").

While §365 addresses leases and executory contracts, the enforceability of an ipso facto agreement is not limited to executory contracts and leases under §365. Indeed, any such agreement, whether in a lease or a security agreement, is subject to court approval and review. Farm Credit of Cent. Fla. ACA v. Polk, 160 B.R. 870 (Bankr. M.D. Fla. 1993); In re Randall Enterprises Inc. 115 B.R. 292 (Bankr. D. Colo. 1990); In re Powers, 170 B.R. 480 (Bankr. D. Mass. 1994).

Despite the rejection of ipso facto agreements by certain courts, and the underlying motives, creditors continue to strive to find alternate methods to avoid the consequences of a bankruptcy proceeding.

Bankruptcy Remote Entities

Due partially to courts' unwillingness to enforce ipso facto agreements, creditors became creative in their efforts to avoid bankruptcy. In fact, creditors created a new entity by which a creditor could effectively avoid a bankruptcy proceeding. Such entities are referred to as bankruptcy remote entities because they are allegedly remote from any potential bankruptcy filing.

A bankruptcy remote entity is created by structuring the entity and/or its board of directors or similar management to inhibit its ability to file, or consent to the filing of, a bankruptcy petition. For example, the creditor requires the debtor to create a new entity, or modify the structure of the current entity, to provide that consent to file a bankruptcy petition may occur only upon unanimous consent of that entity's board of directors, or similar management. The creditor then requires that one or more of its representatives sit on the debtor entity's board of directors, who will presumably block any vote to file a bankruptcy proceeding.

Since unanimous consent is required, and the creditor-controlled director will not vote for a bankruptcy filing, the debtor cannot file for bankruptcy. Such a corporate structure seems ideal for a creditor seeking to avoid a bankruptcy proceeding. However, such a corporate structure is fraught with peril for the creditor placing a representative on the board of directors.

Directors carry a certain amount of control over the debtor. Additionally, as a director, fiduciary duties are due to the debtor entity and possibly other creditors. These duties often conflict with the duties owed by the creditor/director to the creditor itself, particularly when default or financial strife may exist.

To make matters more complicated, certain judicial opinions enhance fiduciary duties when an entity is in the "zone of insolvency." See LaSalle Nat'l Bank v. Perelman, 82 F.Supp. 2d 279, 290 (D. Del. 2000); Geyer v. Ingersoll Publications Co., 621 A.2d 784, 789 (Del. Ch. 1992). These opinions make clear that directors have duties not only to the corporate entity itself, but also to all creditors of the debtor corporate entity. See Id. at 200 (citing Geyer v. Ingersoll Publications Co., 621 A.2d 784, 787-88 (Del. Ch. 1992) (upon insolvency the fiduciary duties owed shift from shareholders to creditors)). Because of the conflicting duties, creditor directors often have no choice but to resign to avoid a fiduciary duty quandary.

Therefore, using a bankruptcy remote entity is not necessarily an attractive alternative. Additionally, the creation of a bankruptcy remote entity does not prohibit the filing of an involuntary petition against that entity. In re Kingston Square Assocs., 214 B.R. 713 (S.D.N.Y. 1997). Thus, one seeking to alter rights in bankruptcy must consider alternate methods.

Alternate Means of Controlling Your Bankruptcy Fate

Despite the problems with previous attempts to affect the rights of a debtor in bankruptcy, there are means for a creditor to control its fate when a bankruptcy is filed. After all, the automatic stay applies only to property of the estate. While the definitions of property of the estate may include any property of the debtor, if all legal and equitable title is removed, then such property is not property of the estate.

Thus, using escrow accounts, trusts and other instruments can sufficiently remove a debtor's property interests. Additional means exist and are supported by the UCC, such as acceptance in satisfaction. Specifically, Revised Article 9 provides that a creditor may accept property in full or partial satisfaction of the secured obligations without the necessity of possession. In re Talbot, 254 B.R. 63, 67-8 (Bankr. D. Conn. 2000); In re Stephens, 221 B.R. 290, 295-97 (Bankr. D. Maine 1998); In re Raymond, 1990 WL 471854 (Bankr. D. Maine 1990).

While using these additional means is not always practical, they can act to terminate a debtor's property rights, transforming property into the creditor's property and leaving a bankruptcy estate without a property interest.

Conclusion

The reality is that bankruptcy is difficult to avoid and virtually impossible to prevent. Despite the creative methods developed to alter rights under the Bankruptcy Code, the bankruptcy court has the ultimate power to determine the validity and enforceability of these provisions and acts. Since the bankruptcy court determines rights and property interests, no such means are guaranteed success. So what is a creditor to do? Hire good bankruptcy counsel.

Journal Date: 
Monday, April 1, 2002

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