The Bankruptcy Code’s Effect on a Drafter’s Ability to Restrict Assignment and Provide for Termination on Bankruptcy

Drafters should be aware of laws that can trump provisions of a given contract.

A good example of this is the way the U.S. Bankruptcy Code can render unenforceable contract provisions that restrict assignment of rights under a contract or give a party the right to terminate if the other party files for bankruptcy.

To improve my own knowledge, I consulted a useful article on the subject, Michelle Morgan Harner, Carl E. Black & Eric R. Goodman, Debtors Beware: The Expanding Universe of Non-Assumable Contracts in Bankruptcy, 13 American Bankruptcy Institute Law Review 187 (2005). For my own benefit, I summarized the key points from the perspective of the contract drafter. I’m now posting that summary, in case it’s of any use to those corporate lawyers who are as ill-informed about this subject as I was.

It’s not my style to offer generalized guidance without recommending specific contract language, but this area is sufficiently new to me and sufficiently specialized that it would be rash of me to offer any contract language just yet.

Restrictions on Assignment

Section 365(f) of the Bankruptcy Code permits a debtor to assume and assign to another an executory contract or unexpired lease. For these purposes, an executory contract is a contract with performance remaining due on both sides. (Note that while I think it’s unhelpful to refer to assignment of a contract as opposed to rights under a contract, for purposes of this summary I’ll mostly stick with the terminology used in the Code and in the Debtors Beware article.)

A given contract may prevent or restrict a party from assigning its rights under that contract, but section 365(f)(1) of the Code states that a debtor may assume and assign an executory contract or unexpired lease “notwithstanding a provision in [the] executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease.”

But section 365(c)(1) of the Code states that unless the nondebtor party consents, a “trustee may not assume or assign any executory contract or unexpired lease of the debtor … if applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or debtor in possession.”

In certain respects sections 365(f) and 365(c)(1) conflict. Courts generally have given effect to section 365(c)(1) when assigning a given contract conflicts with a specific nonbankruptcy law that would excuse the nondebtor party from accepting performance under the contract from another person and the identity of the original contracting party is significant.

Consequently, this exception is often referred to as the “personal services contracts” exception to section 365(f)(1) of the Code. But this exception has been expanded to include a range of contracts that under state law generally wouldn’t qualify as personal service contracts, such as partnership agreements, intellectual property licenses, government contracts, franchise agreements, and limited liability company agreements.

Termination in the Event of Bankruptcy

Some courts have held that if a contract falls within the scope of section 365(c)(1), the debtor is prohibited not only from assigning the contract to another party but also from assuming the contract for the benefit of the reorganized debtor.

What position a court takes on this issue depends on whether it uses the “actual” or “hypothetical” test to interpret section 365(c)(1).

Courts that have adopted the actual test interpret this provision as applying only when the debtor actually seeks to assign an executory contract that cannot be assigned under applicable nonbankruptcy law. Courts that have adopted the hypothetical test interpret this provision as prohibiting the assumption of any executory contract—regardless of whether the debtor actually seeks to assign the contract—if applicable law prohibits assignment of that contract. So under the hypothetical test, a debtor couldn’t assume an executory contract even if applicable law permitted or was silent on assumption of that contract.

Ipso Facto Clauses

What if a contract contains a provision to the effect that the contract terminates if a party files for bankruptcy? (Such provisions are commonly known as “ipso facto clauses.”) The analysis is essentially the same.

Section 365(e)(1) of the Code states that ipso facto clauses are unenforceable in bankruptcy. But section 365(e)(2) states that an ipso facto clause is not invalid if “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 ….”

The language of section 365(e)(2) of the Code closely tracks the language of section 365(c)(1), so to determine whether an ipso facto clause is enforceable under section 365(e)(2), first you have to determine whether the contract falls under section 365(c)(1). As outlined above, this will largely depend on the type of contract and whether a court applies the actual or hypothetical test. A court that applies the actual test would likely invalidate any ipso facto clause; one that applies the hypothetical test would likely find it valid.

Relief from the Automatic Stay

In this context, note also that at least one court has held that debtors can continue to exercise their rights under executory contracts during the pendency of the bankruptcy case even when the contracts or leases in question cannot be assumed under section 365(c)(1) of the Code. If the debtor is viewed as retaining its rights under an executory contract or unexpired lease during the bankruptcy even if those rights cannot be assumed, then the nondebtor party must first obtain relief from the automatic stay before it attempts to extinguish the debtor’s contractual rights.

Tips for the Drafter

The Debtors Beware article ends with some practice tips. Of interest to me were those relating to drafting.

Tips for Nondebtor Contract Parties

Anyone negotiating a contract that is personal in nature should consider making sure that that is reflected in the recitals, particularly if the other party is a financially troubled entity—establishing that a contract is personal in nature could help ensure that the contract falls under section 365(c)(1) of the Code and so cannot be assumed (depending on the court’s approach) or assigned by the trustee.

In this regard, relevant information might include the nondebtor party’s need for a specialized service or widget and the potential debtor’s unique ability to provide that service or widget. More subtle language could include a reference to a particular federal or state law that is intended to govern the contract and arguably draws the contract under section 365(c)(1) of the Code.

A bankruptcy court could decline to give much weight to such language, but such language nevertheless could assist the nondebtor party in satisfying its evidentiary burden at any hearing before the bankruptcy could or, at least, enhance the nondebtor party’s leverage in any negotiations with the debtor regarding treatment of the contract in bankruptcy.

The nondebtor should also include an ipso facto clause, as it would be enforceable if the contract is subject to section 365(c)(1).

The nondebtor may also want to include financial reporting and notice provisions, so as to be able to monitor the potential debtor’s financial condition and take appropriate action.

Finally, the nondebtor should resist any attempt by the potential debtor to take a security interest in the subject matter of the contract, as discussed below.

Tips for Potential Debtors

Any potential debtor that is negotiating a contract should resist including any language aimed at demonstrating that the contract is personal in nature and should instead request that the other party consent to assumption—or even assumption and assignment—of the lease by the potential debtor. (To be consistent, the potential debtor should also resist including an ipso facto clause.)

If the contract is not intended to be personal, the potential debtor should ensure that the contract makes that clear, either by means of appropriate recitals or by providing objective performance standards, and should also provide that if the potential debtor is unable to perform, it may substitute the performance of another widget supplier, delegate its obligations, or otherwise assign the contract.

And the potential debtor could seek to take a security interest in the subject matter of the contract. Having such a security interest would give the potential debtor the right to foreclose on the security interest if the nondebtor party refuses to perform, including by unreasonably withholding consent to continued performance by the debtor and, potentially, assignment by the debtor. Such a security interest could deter the nondebtor party from raising any issues relating to section 365(c)(1) in any subsequent bankruptcy case, as the nondebtor could risk losing all its right in the subject matter of the contract. Of course, getting the nondebtor to grant such a security interest could be a challenge.

(This summary was excerpted from the article Debtors Beware: The Expanding Universe of Non-Assumable Contracts in Bankruptcy, 13 American Bankruptcy Institute Law Review 187 (2005), No. 1, with permission from the American Bankruptcy Institute (www.abiworld.org).)

About the author

Ken Adams is the leading authority on how to say clearly whatever you want to say in a contract. He’s author of A Manual of Style for Contract Drafting, and he offers online and in-person training around the world. He’s also chief content officer of LegalSifter, Inc., a company that combines artificial intelligence and expertise to assist with review of contracts.