What is an ipso facto clause? The phrase ipso facto is Latin for “by the fact itself.” Ipso facto clauses are sometimes included in lease and purchase contracts, and they assert that if the lessee or purchaser becomes insolvent, or files for bankruptcy protection, then the contract has been breached. In other words, under such a clause the very act of filing for bankruptcy protection constitutes a breach of contract (hence the appellation, ipso facto clause) that absolves the other party of any further contract obligations.
Are such clauses valid? The short answer is: No.
I. The Doctrine Of Federal Preemption
Recall that the Bankruptcy Code was made pursuant to Congress’ Constitutional power: “The Congress shall have power to . . . establish . . . uniform laws on the subject of bankruptcies throughout the United States . . .” U.S. Const. art. I, § 8.
Why is this important?
Article VI of the U.S. Constitution provides:
This Constitution, and the laws of the United States which shall be made in pursuance thereof . . . shall be the supreme law of the land; and the judges in every state shall be bound thereby, anything in the Constitution or laws of any state to the contrary notwithstanding.
As we saw in above, the Bankruptcy Code was enacted “in pursuance” of the U.S. Constitution, so it is part of the supreme law of the land. This means that your bankruptcy filing will trump any conflicting contract provision made under state law.
II. The Bankruptcy Code On Ipso Facto Clauses
There are several places in the Bankruptcy Code that render ipso facto clauses null and void.
A. Executory Contracts And Unexpired Leases
11 U.S.C. § 365 deals, in excruciating detail, with executory contracts and unexpired leases. It makes provision for assuming and rejecting leases, and for curing prepetition defaults. It also states:
Paragraph (1) of this subsection [dealing with contract defaults] does not apply to a default that is a breach of a provision relating to— . . . (B) the commencement of a case under this title; . . .
11 U.S.C. § 365(b)(2)(B).
And § 365 also has the following provision (with emphasis added):
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— . . . the commencement of a case under this title.
11 U.S.C. § 365(e)(1)(B).
In other words, the commencement of a bankruptcy case does not constitute a contract default.
B. Impairment Of Claims In Chapter 11
In a Chapter 11 bankruptcy case an impaired claim typically receives different treatment than an unimpaired claim. An impaired claim is one in which the claimant will be treated differently from the way it would have been treated under the terms of the prepetition contract underlying the claim. In 11 U.S.C. § 1124, the filing of a bankruptcy case does not constitute an impairment of a claim (with emphasis added):
Except as provided in section 1123(a)(4) of this title, a class of claims or interests is impaired under a plan unless . . . the plan . . . notwithstanding any contractual provision or applicable law . . . — . . . cures any such default that occurred before or after the commencement of the case under this title, other than a default of a kind specified in section 365(b)(2) of this title . . .
11 U.S.C. § 1124(2)(A) (which refers to the previously discussed § 365(b)(2)).
Thus, the filing of a bankruptcy does not impair a creditor’s prepetition contractual right, and an ipso facto clause cannot change that fact.
C. Estate Assets
Finally, 11 U.S.C. § 541(c) provides that an ipso facto clause cannot change the nature of the debtor’s assets that become property of the bankruptcy estate upon the filing (with emphasis added):
[A]n interest of the debtor in property becomes property of the estate under subsection (a)(1), (a)(2), or (a)(5) of this section notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law— . . . that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.
In sum, ipso facto clauses are generally unenforceable in bankruptcy.
III. Why Do Ipso Facto Clauses Exist?
If ipso facto clauses are unenforceable, why would a creditor put one into a contract? There are at least two reasons.
First, the portion of an ipso facto clause that triggers contract termination upon insolvency can be used to terminate the contract if no bankruptcy case is actually filed. However, if a bankruptcy case is filed shortly after the contract termination due to insolvency, the debtor may be able to appeal to the aforementioned statutory provisions to resurrect the contract.
Second, 11 U.S.C. § 365(e)(2) has a very limited carve-out that provides that an ipso facto clause can be valid if :
. . . 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 . . .
For example, suppose Jonas Kaufman is contractually obligated to sing the role of Siegmund in Die Walküre at the Met (he did so in a recent Met broadcast, and he was great), and he files for Chapter 7 bankruptcy protection prior to the performance. Suppose further that the Chapter 7 Trustee wishes to assume the contract. The Metropolitan Opera Company is not obligated to allow the Trustee to assume the contract because the Trustee cannot sing Wagner to save his life, and applicable contract law excuses the Met from accepting the Trustee’s pathetic singing in lieu of Mr. Kaufman’s superlative singing.
Of course, as with any bankruptcy question, you should always consult a highly skilled bankruptcy attorney before making any decisions about filing