Termination on bankruptcy or insolvency clauses are standard in most contracts. These provisions generally provide that when a party faces bankruptcy or insolvency, the other party can terminate the agreement. As common as they are in contracts, termination on bankruptcy clauses are largely unenforceable. We asked restructuring attorney Rachel Albanese to explain why and how the Bankruptcy Code voids such clauses and to share some exceptions to the rule.
Rachel Albanese is a Restructuring partner at DLA Piper.
The Standard Termination on Bankruptcy Provision
A common termination clause, often known as an ipso facto clause:
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.
Why Are Termination on Bankruptcy Clauses Generally Unenforceable?
11 U.S.C. § 365(e) prohibits a creditor from terminating a contract because of a debtor’s bankruptcy or insolvency:
Notwithstanding a provision in an executory contract or unexpired lease … 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.
The purpose of Chapter 11 is to rehabilitate the debtor and allow reorganization of its interests. “Once a debtor files for bankruptcy, it creates an estate, and all of the debtor’s property belongs to that estate,” Albanese explains. 11 U.S.C. § 541. The prohibition on termination rights gives the debtor reasonable opportunity to reorganize under Chapter 11 before that right can be exercised.
What Is an Automatic Stay?
A bankruptcy filing triggers an automatic stay which suspends all actions against the debtor. 11 U.S.C. § 362. The automatic stay gives debtors a breathing spell and prevents “a race to the courthouse,” blocking any one individual creditor from attempting to satisfy their claims at the expense of other creditors or the debtor's restructuring efforts.
If Termination Provisions Are Largely Unenforceable, Why Are They Still Standard?
While largely unenforceable, ipso facto clauses remain common in contracts. As Albanese points out, attorneys may be reluctant to alter the form of the precedent. Beyond sheer force of habit, termination for insolvency clauses are sometimes included because they may also be enforceable outside of bankruptcy or in agreements for complex financial contracts like loans, hedges, and derivatives. 11 U.S.C. § 365(e)(2) sets forth the exceptions:
(2) Paragraph (1) of this subsection does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if--
(A)(i) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties;
and (ii) such party does not consent to such assumption or assignment;
or (B) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor.
Joel Cohen (JC): In contract negotiations, attorneys regularly demand a termination right where the other party is facing insolvency or bankruptcy. As common as these provisions are, we were surprised to learn that they’re broadly unenforceable. Hello, and welcome to TalksOnLaw. I’m Joel Cohen. We’re joined remotely today by Rachel Albanese, a bankruptcy partner at the global law firm DLA Piper. Rachel, welcome to TalksOnLaw.
Rachel Albanese (RA): Thank you.
JC: Before we go on, what I said in the introduction, these provisions, they’re everywhere. Are they actually unenforceable?
RA: Yeah, it’s surprising, but those provisions are generally unenforceable.
JC: Maybe we can start with, what does the basic language in a contract look like for one of these termination rights?
RA: It says that upon a party’s insolvency or bankruptcy or similar proceeding, that the other party can terminate the contract.
JC: What is the law trying to accomplish by interfering with individuals’ abilities to negotiate?
RA: It goes to the creation of the bankruptcy estate upon a debtor’s filing for bankruptcy. So once a debtor files for bankruptcy, it creates an estate, and all of the debtor’s property belongs to that estate. The goal of Chapter 11 is to rehabilitate the debtor, and the debtor needs its property to accomplish that goal. So upon the filing, Congress has said that there’s an automatic imposition of a stay of creditor action against the debtor and its property, and we call that the automatic stay.
JC: What’s the purpose for the automatic stay?
RA: The automatic stay is meant to prevent what we call a “race to the courthouse.” And that is to ensure that all similarly situated creditors get treated equally with respect to the priority of their claims against the debtor. And so it essentially ensures equal treatment of creditors; It gives the debtors a breathing spell, which is very important, and oftentimes one of the primary reasons for a filing.
JC: The stay slows everything down. Is that also what invalidates these termination rights?
RA: There’s a separate provision of the bankruptcy code, 365e, which prohibits a counter party from terminating a contract simply because of a debtor’s bankruptcy or insolvency.
JC: Rachel, are there any exceptions where these termination rights can actually be enforced?
RA: Yes, there are a handful of exceptions. One is where applicable non-bankruptcy law permits it, one is if it’s a contract to make a loan or a financial accommodation, and one is, for example, with complex financial contracts such as hedges, derivatives, forward contracts and the like.
JC: So these provisions are largely unenforceable. You mentioned some exceptions. Why are they still being drafted in contract over contract?
RA: That’s a good question. I think it’s partly because this provision is a standard provision in many contracts and lawyers may be reluctant to alter the form of the precedent, but also potentially because it may be enforceable outside of a bankruptcy proceeding.
JC: So before we let you go, advice to those who are reviewing their contracts and wondering if their termination rights are in fact enforceable.
RA: Well, first I would say call a bankruptcy lawyer. But the default assumption should be that the contract termination right is not enforceable upon a counterparty’s bankruptcy or insolvency.
JC: Rachel Albanese, thank you for joining us today and explaining this myth of a termination right where the other party is facing insolvency or bankruptcy.
RA: Thank you, it was my pleasure to join you at TalksOnLaw.