The "Devil's Dictionary" is a quick-reference guide for commercial lenders and other restructuring professionals. In this series, we highlight many of the buzz words found in the Dictionary and used in today's bankruptcy arena.
IPSO FACTO CLAUSE/PROVISION: A contract clause that terminates or modifies, or grants the non-debtor party the right to terminate or modify, the contract upon the debtor’s bankruptcy filing or the insolvency or financial condition of the debtor. The Code does not use the phrase “ipso facto clause” but refers, instead, more verbosely (but also more precisely) to “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...”
Most ipso facto clauses in most circumstances are unenforceable, leading to the common misconception that the Code voids all ipso facto clauses for all purposes. The Code only voids ipso facto clauses for certain purposes and only under certain circumstances.
For example, under Section 541(c)(1)(B), an interest of the debtor becomes property of the estate despite any ipso facto clause. Under Section 363(1), the debtor may use, sell, or lease property despite an ipso facto clause. Subject to meeting the requirements of Section 365, the debtor may also assign an executory contract or unexpired lease despite an ipso facto clause purporting to bar assignment upon the debtor’s bankruptcy filing (see Assumption and Assignment of Executory Contracts and Unexpired Leases).
Personal liability of the borrower on an otherwise nonrecourse debt, triggered by the occurrence of a stated contingency such as a bankruptcy filing by the borrower. Section 365(e)(1) invalidates ipso facto clauses in executory contracts and unexpired leases, but a debt instrument qualifies as neither. Nevertheless, in some instances bankruptcy courts have refused to enforce ipso facto clauses beyond the context of executory contracts and unexpired leases. Whether a court would enforce a springing recourse provision triggered by the borrower’s bankruptcy filing is not a settled question of law. Springing recourse is unlike a Springing Guaranty where the borrower’s filing creates recourse for a third party guarantor and not the borrower/debtor itself. Note also that such a “springing recourse” provision is sometimes unnecessary in Chapter 11 because, under certain circumstances, Section 1111(b)(1)(A) converts nonrecourse debt to recourse for purposes of a Chapter 11 case. But Section 1111 does not confer that benefit in a Chapter 7 or Chapter 13 case.
Under Section 365(e), a contract may not be terminated or modified due to an ipso facto clause unless the contract is a “personal service contract,” that is, a contract where “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.” (See Personal Service Contract). Thus, the Code actually reads into a “personal service contract” an ipso facto clause even if the contract itself does not contain one. Likewise, while Section 365(f) generally voids ipso facto clauses terminating or modifying a contract on assumption or assignment by the trustee or debtor, “personal service contracts” are again exempted by Section 365(c) whether or not they contain a provision restricting or preventing assignment or delegation of duties.
Bankruptcy Code §§ 363(1), 365(c), 365(e), 365(f), 541(c)(1)(B). See also Assumption and Assignment of Executory Contracts and Unexpired Leases, Executory Contract, Personal Service Contract.
The "Devil's Dictionary" is an excellent reference tool that reflects the collective wisdom of its four authors, Brett Anders, Jim Bird, David Ferguson, Dan Flanigan, and digital editor, Christopher Ward, who have a combined total of more than 130 years working in the forefront of real estate and other commercial finance, loan enforcement, financial restructuring and bankruptcy law.
