A fixture of many different kinds of business contracts is the termination-on-bankruptcy (or “ToB”) provision. It states that if the party in question experiences bankruptcy or any of a series of related circumstances, then depending on the contract, either the other party may terminate the contract or the contract will terminate automatically.
Such a provision is usually referred to as an “ipso facto clause,” ipso facto meaning “by the very nature of the situation.” The fewer obscure Latinisms in the practice of law, the better, hence our more straightforward label.
In the United States, bankruptcy law restricts enforceability of ToB provisions. Nevertheless, in certain circumstances they are enforceable; the purpose of this article is to propose model language for such circumstances, with the language following the guidelines in Kenneth A. Adams, A Manual of Style for Contract Drafting (3d ed. 2013). It also offers generic model language for contracts governed by a law other than the law of one of the U.S. states.
As the name suggests, ToB provisions can provide for termination, but drafters also use them to specify that any of the stated circumstances will constitute an event of default having specified consequences that might or might not include termination.
Furthermore, ToB provisions occur in contracts either as a stand-alone provision or as part of a broader provision stating other circumstances that can lead to termination or an event of default.
As regards whether a ToB provision gives rise to a right to terminate or causes the contract to terminate automatically, that depends on whether the party having the benefit of the provision prefers to retain control or whether it is sufficiently concerned at the prospect of any of the specified events occurring that it wishes to have occurrence act as an automatic trigger.
Due to operation of three provisions of the Bankruptcy Code, ToB provisions conditioned on insolvency of the debtor or its financial condition, or commencement of a bankruptcy case of the debtor, are generally unenforceable in bankruptcy.
First, section 541(c) of the Bankruptcy Code strikes down ToB provisions that in effect enable the nondebtor party to forfeit property of the bankruptcy estate.
Second, section 363(l) of the Bankruptcy Code overrides ToB provisions that prevent the debtor from using, selling, or leasing its property.
And third, section 365(e)(1) of the Bankruptcy Code states that a ToB provision in an executory contract – a contract with performance remaining due on both sides – is unenforceable in bankruptcy.
But section 365(e)(2) of the Bankruptcy Code, in conjunction with section 365(c)(1), provides that a ToB provision is not invalid if the debtor or trustee is not permitted by applicable law to assume or assign the executory contract. So if by law an executory contract cannot be assumed by the debtor or trustee without the other party’s consent, then the nondebtor party can use the ToB provision to force rejection of the contract. See Kenneth A. Adams, The Bankruptcy Code’s Effect on a Drafter’s Ability to Restrict Assignment and Provide for Termination on Bankruptcy, Adams on Contract Drafting (Aug. 7, 2006).
This basis for enforcing a ToB provision is commonly referred to by bankruptcy lawyers as the “personal services” exception. The relevant caselaw is complex and beyond the scope of this article, but an example of a context where this exception would apply is when the promised performance by the debtor is so distinctive that it wouldn’t be reasonable to expect that another could render it. That might be the case if, for example, the debtor were a noted opera singer.
Furthermore, the Bankruptcy Code would render a ToB provision unenforceable only if a bankruptcy is actually filed. If a contract party is insolvent and no bankruptcy case is ever filed, it’s possible that the other party could use an appropriately worded ToB provision to terminate the contract. See Robert L. Eisenbach III, Are “Termination on Bankruptcy” Contract Clauses Enforceable?, In the (Red): The Business Bankruptcy Blog (Sept.16, 2007).
Finally, safe harbors in sections 555, 556, 559, 560, and 561 of the Bankruptcy Code permit enforcement of ToB provisions in specified securities and financial market transactions.
Given that in certain contexts ToB provisions are enforceable, it would be best that they be clear and concise. That’s the focus of the remainder of this article.