Vestiges of Things Past: Ipso Facto Clauses and Bankruptcy

“Since the lease of my bankrupt tenant provides that the lease automatically terminates upon the tenant’s bankruptcy, is it okay if I take the space back?”

When a client learns that this type of automatic, ipso facto termination clause generally is unenforceable in bankruptcy, the client is usually confused and asks, “Then why bother to include such a clause in a lease, if the clause is unenforceable?”

As usual, there are any number of answers to this question. The simplest answer is probably that clauses terminating a contract due to a party’s insolvency were enforceable under the prior Bankruptcy Act. See, e.g., Reloeb Co. v. LTV Corp. (In re Chateaugay Corp.), No. 92 Civ. 7054, 1993 WL 159969, *5 (Bankr. S.D. N.Y. May 10, 1993). While such automatic termination clauses generally are not enforceable under the current Bankruptcy Code, 11 U.S.C. §§ 101 et seq., which was first enacted in 1978, one never knows when there will be a change in the law. More importantly, not every clause that initially appears to be an ipso facto clause is unenforceable, and not every insolvent contract party files bankruptcy. To assist contracting parties through the quagmire of ipso facto clause jurisprudence, this article provides an overview of Section 365(e) of the Bankruptcy Code, the section that both invalidates ipso facto clauses and sets forth the exceptions to this rule.

Section 365(e)

Section 365 of the Bankruptcy Code contains the rules by which a debtor, with bankruptcy court approval, can assume, reject, or assume and assign executory contracts and unexpired leases, including certain specific rules applicable to particular types of contracts such as intellectual property licenses and shopping center leases. Subsection (e)(1) of Section 365 prohibits enforcement of the certain types of clauses which appear in many sorts of contracts and leases:

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.

See 11 U.S.C. § 365(e)(1). The foregoing provision is designed to prevent the forfeiture of valuable contract and lease rights of the debtor simply as a result of the debtor’s insolvency, as such contract and lease rights often can be key to the debtor’s ability to reorganize and/or to maximize the recovery for creditors.

As is usually the case, there are exceptions to this general prohibition, which are set forth in Subsection (e)(2) of Section 365:

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 and 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.

See 11 U.S.C. § 365(e)(2). The invalidation of defaults resulting ipso facto from insolvency or bankruptcy and the exceptions to this prohibition mirror and work in tandem with the limitations on assumption – and assumption and assignment – of contracts that are set forth elsewhere in Section 365. In particular, the exceptions set forth in Section 365(e)(2) reflect the Bankruptcy Code’s general policy of balancing the relief that the Bankruptcy Code affords a debtor while protecting the rights of the non-debtor parties to an executory contract or unexpired lease. The exceptions also incorporate settled state law protecting parties to personal services contracts and contracts to provide financing or other financial accommodation.

Section 365(e) in Practice

Notwithstanding the fact that insolvency-triggered termination clauses usually are not enforceable in bankruptcy, the non-debtor party should have a bankruptcy attorney review the lease or contract because not all clauses that appear to be ipso facto clauses really qualify as such. In addition, there may be a way to terminate the unexpired lease or executory contract without violating the automatic stay that comes into effect under the Bankruptcy Code upon the filing of a bankruptcy case.

For example, under Section 365(e)(1) of the Bankruptcy Code, the non-debtor party cannot terminate an executory contract or unexpired lease that is in effect as of the petition date. However, this prohibition on termination lasts only for so long as the term of the contract or lease plus any applicable option or cure periods. This means that Section 365(e) cannot prolong the life of a lease that terminates as a result of the passage of time or due to a failure to comply with a condition set forth in the lease, as opposed to the filing of a bankruptcy case. See, e.g., In re Margulis, 323 B.R. 130, 135 (Bankr. S.D. N.Y. 2005) (finding that agreement to settle litigation claim at lower figure terminated post-petition according to its provisions and therefore no longer could be assumed by debtor in his Chapter 11 case). As the bankruptcy court explained in Margulis, “if the termination or modification is triggered by a condition other than one of [the three conditions set forth in Section 365(e)], it will not be invalidated by § 365(e)(1).”

Likewise, Section 365(e) does not necessarily invalidate other provisions of an executory contract or unexpired lease that increase the financial responsibilities of the debtor or otherwise benefit the non-debtor party to the detriment of the debtor, as long as the application of such provisions is not triggered by the debtor’s insolvency, financial condition or the commencement of a bankruptcy case. For example, the debtor in In re Yates Dev., Inc., 256 F.3d 1285 (11th Cir. 2002), sought to assume a pre-petition option contract to purchase property, but sought not to comply with the “time of the essence” paragraph in the contract, by which the purchase price increased by $5,000 for every day past a specified date that the closing took place. Although the debtor argued that the clause was an unenforceable penalty resulting from the filing of the bankruptcy, the court found that the clause’s operation was not triggered by a default or by the filing of the debtor’s petition. Rather, the clause simply operated to increase the purchase price on a per-day basis if the exercise of the option was delayed for any reason, and was triggered solely as a result of the passage of time. Under the circumstances, the court determined that the clause was not a penalty and that the contract was enforceable. Id. at 1289. See also In re Washington Capital Aviation & Leasing, 156 B.R. 167, 174 (Bankr. E.D. Va. 1993) (finding lease provision that authorized non-debtor party to terminate lease if debtor sold its company to a third party operated to bar proposed sale by debtor and was not an unenforceable ipso facto clause).

If the executory contract provides for the non-debtor party to loan money to the debtor, the exception set forth at Section 365(e)(2)(B) will excuse the non-debtor party from performing. While there is some conflicting case law on this issue, in general this exception is strictly construed to apply only if the gravamen of the contract is to provide a financial accommodation, such as a contract to extend a financing or issue stock in the debtor. See, e.g., Citizens and Southern Nat’l Bank v. Thomas B. Hamilton Co., Inc. (In re Thomas B. Hamilton Co., Inc.), 969 F.2d 1013, 1019 (11th Cir. 1992) (finding “a contract is not one to extend financial accommodations merely because it involves an extension of credit that is incidental to the overall arrangement between the parties.”); In re Neuhoff Farms, Inc., 258 B.R. 343, 348 (Bankr. E.D. N.C. 2000) (contract to supply hogs that contained a price stabilization mechanism was not a financial accommodation contract). The exception generally does not apply to a contract to provide goods or services where payments will be made over time, or to a lease of commercial or residential real property or equipment. However, at least one court has held that a lease that required the non-debtor landlord to provide $150,000 in improvements to the commercial space at issue before the debtor tenant moved in constituted a contract to provide a financial accommodation and thus could not be enforced pursuant to Section 365(e)(2)(B) and could not be assumed by the debtor pursuant to Section 365(c)(2). See In re Postle Enterprises, Inc., 48 B.R. 721, 725 (Bankr. D. Ariz. 1985).

Similarly, if applicable law would otherwise exempt a non-debtor party from accepting performance from or rendering performance to the trustee or to an assignee, then a termination clause premised upon the debtor’s insolvency, financial condition or the filing of a bankruptcy case will be enforceable unless the non-debtor party agrees otherwise. See 11 U.S.C. § 365(e)(2)(B). The most common type of executory contract that falls within this exception is a contract for personal services involving a special relationship between the debtor and the non-debtor party, but other types of executory contracts or leases may fit within this exception as well. See, e.g., Bonneville Power Admin. v. Mirant Corp. (In re Mirant Corp.), 440 F.3d 238, 249-250 (5th Cir. 2006) (discussing application of U.S. Anti-Assignment Act); RCI Tech. Corp. v. Sunterra Corp. (In re Sunterra Corp.), 361 F.3d 257 (4th Cir. 2004) (federal copyright law); Summit Invest. and Dev. Corp. v. Leroux, 69 F.3d 608, 612 (1st Cir. 1995) (discussing interaction of Sections 365(e)(1) and (e)(2)(A) and Massachusetts limited partnership act). Not every contract that appears to fit within this exemption actually does, however. For example, numerous courts have held that a franchise agreement does not constitute a personal services contract subject to Section 365(e)(2)(B). See, e.g., In re Tom Stimus Chrysler-Plymouth, Inc., 134 B.R. 676, 679 (Bankr. M.D. Fla. 1991) (citing cases).

There also is a split in the circuits as to whether the exemption set forth in Section 365(e)(2)(B) and its companion provision, Section 365(c), prevents a debtor-in-possession from assuming, as opposed to assuming and assigning, its own contracts when the non-debtor party does not consent. Some courts apply a “hypothetical test,” finding that these exemptions to the ipso facto rule act to terminate executory contracts or leases whenever applicable law prohibits assignment without the non-debtor party’s consent, even if the debtor is not seeking to assign the contract or even to assume it at that juncture. See, e.g., RCI Tech. Corp. v. Sunterra Corp. (In re Sunterra Corp.), 361 F.3d 257 (4th Cir. 2004); Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 750 (9th Cir. 1999); In re West Elec., Inc., 852 F.2d 79, 83 (3d Cir. 1988). By contrast, other courts apply an “actual test,” finding that the effect of Section 365(e)(2)(A) must be determined as applied to the actual facts and circumstances of the case and, particularly, whether the contract is being assumed by the debtor or if the debtor is seeking to assume the contract for purposes of assigning it. See, e.g., Mirant, 440 F.3d at 249-250; Summit Invest., 69 F.3d at 612; In re Footstar, Inc., 337 B.R. 785, 789-790 (Bankr. S.D. N.Y. 2005).

Just as the non-debtor landlord or contracting party cannot use a debtor’s financial condition or a debtor’s bankruptcy case as a basis for terminating an executory contract or lease, neither can the debtor rely on such a clause as a basis for cutting off the non-debtor party’s pre-petition claim. For example, in In re Cornwall Paper Mills Co., 169 B.R. 844 (Bankr. D. N.J. 1994), the debtor argued that its landlord’s claim for pre-petition rent due and owing on a commercial lease should be cut off as of the date that the debtor ceased operating and/or as of the date that a fiscal agent was appointed to take possession of the debtor’s assets, both of which occurred months before the petition date, because the lease provided that it would automatically terminate upon the debtor’s insolvency or the appointment of a receiver. The bankruptcy court rejected this argument, finding that this lease provision granted the option to terminate to the landlord only and, in any event, was rendered ineffective by Section 365(e) once the debtor commenced its bankruptcy case. Id. at 848-849. Accordingly, the debtor is not permitted to use Section 365(e) as a sword to cut off the damages it owes to a non-debtor party.

Conclusion

As is evident from this short overview, once a party to an executory contract or unexpired lease files for protection under the Bankruptcy Code, the non-debtor party to such contract or lease must be careful, as application of Section 365(e) can be, but is not necessarily, a simple matter. It is important to look at the following: (a) the facts and circumstances of each case, to determine if any exceptions to the ipso facto clause prohibition apply; and (b) the law of the particular circuit, to determine if the executory contract or lease can be terminated post-petition and, if so, under what circumstances. In any case, consulting with an experienced bankruptcy attorney can help avoid unwitting violations of the automatic stay and any associated penalties, as well as protect the non-debtor party’s rights in the event that the counterparty to the contract or lease files for protection under the Bankruptcy Code.
 

For more information, e-mail Barbra R. Parlin at barbra.parlin@hklaw.com or call toll free, 1.888.688.8500.