A trustee or debtor-in-possession is provided with a plethora of powers under title 11 of the United States Code (the “Bankruptcy Code”). A chapter 13 debtor-in-possession, pursuant to section 1322 of the Bankruptcy Code, may assume or reject any executory contract in connection with its plan. The ability, however, to assume or reject an executory contract is limited by section 365, which in part prohibits the modification or termination of a debtor’s interest in a contractual agreement on the sole basis that the debtor filed for bankruptcy, which is commonly known as an ipso facto provision. This prohibition of ipso facto provisions is not limited to executory contracts or unexpired leases. Section 541(c)(1)(B), ensures any interest of a debtor in property becomes property of the bankruptcy estate. Courts are reluctant to enforce contract provisions contingent on the filing of bankruptcy, whether found in executory or non-executory contracts, as these provisions tend to deprive the bankruptcy estate of valuable interests necessary to restore the debtor’s financial solvency.
A Washington District Court, in In re Eustler, upheld this longstanding history of finding ipso facto contract provisions unenforceable. In Eustler, the district court found shareholders of a corporation were not entitled to relief from the automatic stay to exercise their contractual right to buy back a debtor’s shares. This is because the court found the shareholder’s agreement, which was dependent on the debtor’s financial condition, unenforceable.
This memorandum discusses the rationale behind the prohibition against terminating equitable interests when debtors file for bankruptcy in three parts. Part I describes ipso facto provisions. Part II focuses on the courts’ interpretations of ipso facto provisions and when contract provisions contingent on a debtor’s financial state may be enforced. Part III examines the consequences of ipso facto provisions.