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When Contracts and Bankruptcy Collide, a Short Term May Be Better in the Long Term

As we learned during the downturn in 2008, the economic climate can change rapidly. When things are going well, many businesses forget the lessons of the past. No matter what industry your business is in, there may be occasions when you are asked to enter into a relatively long-term contract, i.e. longer than three years. Such agreements are sometimes favorable because of the stability and predictability they can provide. However, before entering into such an agreement, you should consider that the longer the contract, the greater the risk of a change in the contract counterparty’s financial situation. A safe credit risk in 2017 might find itself filing for bankruptcy by 2020.

If your response is: “I am not concerned about the other party filing bankruptcy. I had my attorney include a bankruptcy termination clause in our agreement,” then you may want to think again. The U.S. Bankruptcy Code has a lot to say about the rights of both the debtor and the non-debtor party once a bankruptcy is filed – often to the chagrin of the non-debtor party.

It is true that many business agreements contain clauses that provide that a party filing bankruptcy is deemed to have breached the agreement, and the other party may terminate the agreement (a “Right to Terminate” clause). Or the provision might say that if one party files bankruptcy, that party’s rights terminate automatically (an “Automatic Termination” clause).

With a few exceptions, which are beyond the scope of this blog post, these clauses do not work. A Right to Terminate clause is unenforceable because the non-debtor party’s termination would violate the “automatic stay” of Bankruptcy Code section 362. Once a bankruptcy is filed, section 362 puts a halt to any action to obtain possession of, or exercise control over property of the estate. Another section of the Bankruptcy Code, section 541, includes the debtor’s rights under the agreement as property of the bankruptcy estate. From a practical standpoint, this means that the non-debtor party cannot terminate the agreement without seeking permission to do so from the bankruptcy court. And for the reasons discussed below, such permission would likely be denied.

An Automatic Termination clause is also unenforceable. Bankruptcy Code section 541(c) dictates that subject to a limited exception, a debtor’s property becomes property of the bankruptcy estate notwithstanding a contractual provision that purports to modify or terminate the debtor’s rights if a bankruptcy is filed. Accordingly, the Automatic Termination of rights due to the bankruptcy filing is unenforceable under this section.

The Right to Terminate and Automatic Termination clauses are commonly referred to as ipso facto clauses. Section 541(c) specifically makes such clauses unenforceable and sections 363 and 365 of the Bankruptcy Code contain their own ipso facto clause restrictions.

Section 363(l) provides that the trustee may use, sell or lease property notwithstanding a contractual provision that purports to modify or terminate the debtor’s rights if a bankruptcy is filed.

Section 365(e) contains a similar provision to the effect that, subject to certain exceptions, an executory contract of the debtor may not be terminated or modified, even if it states that the contract is terminated upon the filing of a bankruptcy.

The impact of the foregoing is that unless your long-term agreement falls into one of the few exceptions if your contract counterparty files bankruptcy, you will not be able to end your contractual relationship. Instead, your contract may remain in place, your rights will be impacted by other provisions of the Bankruptcy Code in unfavorable ways, and there are very strict limits as to what you can do about it.

However, there is one simple and foolproof way to deal with this potential problem before signing the agreement. Shorten it. Not the number of pages—just the length of the agreed-upon term. The only sure-fire way to escape a contract with a bankrupt debtor is for the contract to expire by its own terms. For instance, if rather than a four-year contract, you entered into a two-year contract, perhaps with the right to extend the contract for an additional two years, you might still have a four-year relationship and reap the same benefits as you would have with a four-year contract. If the other party were to file bankruptcy, for example, after 20 months, you would have only four months until the term expired. Because extending the contract, or agreeing to a new contract, would require an affirmative act on your part, one that you are not required to take, you could simply choose not to seek the extension. The result would be that the contract would simply end four months into the bankruptcy, severely limiting your bankruptcy exposure. A bankruptcy filing protects debtors in a myriad of ways, but it does not extend an otherwise expiring contract. Compare this to your four-year contract. You would be stuck for up to an additional 28 months, probably wishing you could terminate the contract.

Of course, not every proposed long-term contract can be broken up into smaller parts as outlined above. And sometimes the other party will not want you to be able to get out of the contract after only two years. But sometimes, it is an available option. Therefore, it is something that should always be explored. Although it is impossible to predict the future, it is better to consider the short-term option before jumping into a long-term business contract.

Categories: Chapter 11, Chapter 7, Chapter 9, Law Firm Bankruptcies, Preferences