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The Ipso Facto Clause and Bankruptcy

The ipso facto clause is a legal term from Latin words meaning “by the fact itself.” When placed into certain binding and signed contracts, the term simply provides a means for creditors to begin legal termination procedures of the contract under certain circumstances. Insolvency is normally the circumstance most creditors place in any ipso facto clause within a contract. Usually, this means that if a debtor files for bankruptcy or formally writes the creditor they are insolvent, the ipso facto clause goes into effect allowing the creditor to legally begin termination proceedings of the contract. Foreclosing on a house after filing for bankruptcy protection can be an example.

Triggering the Ipso Facto Clause in a Contract

Depending on how they are written in the contract, an ipso facto clause can be triggered automatically or triggered through making a formal notification of intent.

Some things that might trigger the use of the ipso facto clause and begin the termination process are:

  • filing a voluntary bankruptcy;
  • having an involuntary bankruptcy filed against you;
  • making it known to your creditor you are insolvent, usually in writing;
  • assigning assets to various creditors for liquidation purposes; or
  • some other financial condition that can change the covenant of the contract.

How Filing Bankruptcy Effects the Ipso Facto Clause

Once a debtor files for bankruptcy protection, the bankruptcy code prevents enforcement of any type of ipso facto clause without going through the bankruptcy court to get permission to do so.

Section 541(c) of the Federal Bankruptcy Code states any interest in property becomes the “property of the bankruptcy estate.” This primarily means that the debtor does not lose any property due to any contract right. Instead, the property and all its contracts are placed under the jurisdiction of a bankruptcy court that hires a bankruptcy trustee to be the custodian of all the assets belonging to the debtor. Until the debtor’s bankruptcy estate has been legally managed according to federal bankruptcy laws, all assets in the estate will remain under the direction of the bankruptcy trustee. At this point, only the bankruptcy court can effect a forfeiture, modification, or termination of the debtor’s interest in the property regardless of what any ipso facto clause says.

Section 365 (e)(2) of the Federal Bankruptcy Code specifically invalidates any ipso facto clause that might result in forfeiture of an executory or any unexpired lease contract.

In a nutshell, bankruptcy laws effectively stop an ipso facto clause up until a bankruptcy court gives the creditor permission to proceed with termination of the contract or until the bankruptcy is closed. In addition, the automatic stay of bankruptcy prevents the creditors from being able to make any type of collection attempts on the debtor without the permission of the bankruptcy court. Creditors have the right to petition a bankruptcy court to lift the automatic stay and to reinstate an ipso facto clause. Without good reason for doing so, bankruptcy courts have historically denied such requests.

If you are having problems understanding an ipso facto clause in an executory contract you are currently involved, and you are facing bankruptcy, contact a bankruptcy attorney today to help you understand your rights under bankruptcy laws.

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