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PROCEED WITH CAUTION! UNDERSTANDING IPSO FACTO CLAUSES IN BANKRUPTCY
BLOG INSOLVENCY INSIGHTS
The phrase ipso facto is Latin for "by the fact itself." Ipso facto clauses are sometimes included in lease and purchase contracts, and they assert that if the lessee or purchaser becomes insolvent, or files for bankruptcy protection, then the contract has been breached. In other words, under such a clause the very act of filing for bankruptcy protection constitutes a breach of contract that absolves the other party of any further contract obligations.
Such clauses are not valid in bankruptcy; lessors and sellers that may become creditors in a bankruptcy down the line should proceed with caution.
I. Federal Preemption
The Bankruptcy Code was made pursuant to Congress' Constitutional power under Article I, § 8, which provides, in pertinent part:
The Congress shall have power to establish uniform laws on the subject of bankruptcies throughout the United States.
In this regard, Article VI of the Constitution provides:
This Constitution, and the laws of the United States which shall be made in pursuance thereof shall be the supreme law of the land; and the judges in every state shall be bound thereby, anything in the Constitution or laws of any state to the contrary notwithstanding.
Because Bankruptcy Code was enacted "in pursuance" of the U.S. Constitution, it is part of the "supreme law" of the land. This means that a bankruptcy filing will trump any conflicting contract provision.
II. The Bankruptcy Code On Ipso Facto Clauses
There are several places in the Bankruptcy Code that render ipso facto clauses null and void.
A. Executory Contracts and Unexpired Leases
11 U.S.C. § 365 deals with executory contracts and unexpired leases. It makes provision for assuming and rejecting leases, and for curing prepetition defaults. It also states:
Paragraph (1) of this subsection [dealing with contract defaults] does not apply to a default that is a breach of a provision relating to— . . . (B) the commencement of a case under this title; . . .
11 U.S.C. § 365(b)(2)(B).
And § 365 also has the following provision (with emphasis added):
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— . . . the commencement of a case under this title.
11 U.S.C. § 365(e)(1)(B).B.
In other words, the commencement of a bankruptcy case does not constitute a contract default.
B. Impairment Of Claims In Chapter 11
In a Chapter 11 bankruptcy case an impaired claim typically receives different treatment than an unimpaired claim. An impaired claim is one in which the claimant will be treated differently from the way it would have been treated under the terms of the prepetition contract underlying the claim. In 11 U.S.C. § 1124, the filing of a bankruptcy case does not constitute an impairment of a claim:
Except as provided in section 1123(a)(4) of this title, a class of claims or interests is impaired under a plan unless . . . the plan . . . notwithstanding any contractual provision or applicable law . . . — . . . cures any such default that occurred before or after the commencement of the case under this title, other than a default of a kind specified in section 365(b)(2) of this title . . .
11 U.S.C. § 1124(2)(A)
Thus, the filing of a bankruptcy does not impair a creditor's prepetition contractual right, and an ipso factoclause cannot change that fact.
C. Estate Assets
Finally, 11 U.S.C. § 541(c) provides that an ipso facto clause cannot change the nature of the debtor's assets that become property of the bankruptcy estate upon the filing:
An interest of the debtor in property becomes property of the estate under subsection (a)(1), (a)(2), or (a)(5) of this section notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law— . . . that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor's interest in property.
In sum, ipso facto clauses are generally unenforceable in bankruptcy.
Titlemax v Roby, Jurisdiction: D. MD. AL (Date: 9/19/2022) Summary: The court reversed the bankruptcy court's denial of an objection to confirmation based on good faith. The basis of the objection was that the plan was proposed in bad faith because the Debtor had previously signed multiple pawn agreements because the pawn agreement stated "By signing this Agreement, Pledgor represents, warrants, acknowledges and agrees as follows . . . You are not a debtor in bankruptcy. You do not intend to file a federal bankruptcy petition." The Debtor admitted that she was planning on filing a bankruptcy before she signed the last agreement. The bankruptcy court held that this clause was unenforceable as a matter of public policy because it impermissibly attempted to contract away the Debtor's ability to file bankruptcy and declined to enforce the clause. The district court disagreed and reversed the bankruptcy court.
Because they are bad for public policy, courts usually don't like pre-petition deals where a debtor gives up the rights given by the Bankruptcy Code. Agreements made before filing for bankruptcy usually can't be enforced because they go against public policy. However, based on the specifics of the case, such agreements may be enforceable.
How much power do parties have over federal bankruptcy law through settlement deals made before filing? People who don't know much about bankruptcy often think that their prepetition settlement agreements will still be valid even if one of the parties files for bankruptcy. Negotiations for settlements are meant to end legal disputes for good, but many people are surprised to learn that some parts of the deal may no longer be valid after one party files for bankruptcy.
Creditors often ask debtors to give up the safeguards that exist for debtors who have filed a petition under the Bankruptcy Code while they are negotiating settlement agreements, pre-petition forbearance agreements, or plan-support agreements. Courts have long said that a deal made before filing for bankruptcy is null and void because it goes against public policy.
1. For instance, rules that say you can't file for bankruptcy are usually not enforced.
2. A deal to temporarily not file for bankruptcy in the future has even been thrown out by some courts because it would make it harder for the debtor to get bankruptcy protection.
3. People who owe money often are asked to give up the benefits of 11 U.S.C. § 362's automatic stay or to not get a discharge when they file for bankruptcy again in the future. Pre-petition waivers of the automatic stay and the debtor's discharge are typically unenforceable.
But there are times when terms waiving a debtor's bankruptcy protections might be enforceable, so parties should be aware of these situations when they are negotiating agreements. See In re 301 W N. Ave. LLC, 666 B.R. 583, 598 (Bankr. N.D. Ill. 2025)
