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

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Apr 2002

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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.

<h3>Ipso Facto Clauses</h3>

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. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Atrium
Highpoint Ltd. Partnership, 189 B.R. 599 (Bankr. M.D. Fla.
1985)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Madison, 184 B.R. 686 (Bankr. E.D. Pa.
1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Pease, 195 B.R. 431 (Bankr. D. Neb. 1996)</a>;

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re South East Financial Associates Inc., 212 B.R. 1003 (Bankr.
M.D. Fla. 1997)</a>.

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. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Darrell Creek Associates L.P.,
187 B.R. 908 (Bankr. D. S.C. 1995)</a>.

<blockquote><blockquote>
<hr>
<big><center>
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.
</center></big>
<hr>
</blockquote></blockquote>

Indeed, Congress foresaw such agreements and addressed their enforceability in the
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. 11 U.S.C. §365(e)(1)</a>. Specifically, §365(e)(1) states:

<blockquote>
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—

<blockquote>
(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.
</blockquote>
</blockquote>

Collier on Bankruptcy expounds upon §365(e)(1) by stating that:

<blockquote>
[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.</blockquote>

3 Collier on Bankruptcy ¶365.07 (15th ed. 2000) (footnotes omitted);

see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Metrobility Optical Sys. Inc., 268 B.R. 326, 329
(Bankr. D. N.H. 2001)</a> ("§365(e) invalidates ipso facto clauses in
executory contracts and unexpired leases."); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re National Hydro-Vac Indus. Serv.
L.L.C., 262 B.R. 781, 786 (Bankr. E.D. Ark. 2001)</a> ("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."); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pak,

252 B.R. 215, 217 n.1 (Bankr. M.D. Fla. 2000)</a> ("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. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Credit of Cent. Fla. ACA v. Polk, 160
B.R. 870 (Bankr. M.D. Fla. 1993)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Randall Enterprises Inc.
115 B.R. 292 (Bankr. D. Colo. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Powers, 170
B.R. 480 (Bankr. D. Mass. 1994)</a>.

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.

<h3>Bankruptcy Remote Entities</h3>

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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Nat'l Bank v. Perelman,

82 F.Supp. 2d 279, 290 (D. Del. 2000)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Ingersoll
Publications Co., 621 A.2d 784, 789 (Del. Ch. 1992)</a>. 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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Ingersoll Publications Co., 621 A.2d 784, 787-88
(Del. Ch. 1992)</a> (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. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kingston Square Assocs., 214 B.R. 713 (S.D.N.Y. 1997)</a>. Thus, one seeking to alter
rights in bankruptcy must consider alternate methods.

<h3>Alternate Means of Controlling Your Bankruptcy Fate</h3>

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. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Talbot, 254 B.R. 63, 67-8
(Bankr. D. Conn. 2000)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Stephens, 221 B.R. 290,
295-97 (Bankr. D. Maine 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Raymond, 1990 WL 471854
(Bankr. D. Maine 1990)</a>.

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.

<h3>Conclusion</h3>

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 Authors

Bruce H. White

William L. Medford

Journal Date

Monday, April 1, 2002 - 12:00

Bankruptcy Rule

2002