In Bankruptcy Information

Many contracts, including residential leases, service contracts, licenses and supply agreements, have termination provisions that are to take effect automatically upon bankruptcy by one of the parties. These are known as ipso facto clauses. Ipso facto literally means “by the act itself.” As used, the clause supposedly says that the simple act of filing bankruptcy terminates the agreement.

In reality, ipso facto clauses are almost never enforceable. This is so because of the way the Bankruptcy Code treats contracts. A contract, or, more precisely, the rights of the parties under a contract, are potentially valuable assets that the trustee could sell to raise cash to make a payment to creditors, which is the whole point of appointing the trustee. Imagine that the debtor has a lease for five years for commercial property. Suppose that at the time of the lease market rates were low and the rental rate for the five year term is now substantially below the market. This is something that a trustee possibly could sell, assuming the debtor isn’t going to stay in business. That’s just one example of how contracts and leases can have value to the trustee.

As a result of this, the Bankruptcy Code provides, first, that the interest of the debtor in any property (in this case the debtor’s interest under the lease) belongs to the trustee upon filing the case. Secondly, the Bankruptcy Code places an automatic stay, or halt, on any action to dispose of the debtor’s property once the case is filed. This is to preserve whatever is in the debtor’s estate until the trustee can decide what to do with it. Finally, the Bankruptcy Code also prescribes exactly how the trustee can deal with leases and contracts such as this.

When read together, these sections of the Bankruptcy Code operate to make any ipso facto clause pertaining to terminating the contract upon filing bankruptcy invalid.

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