Termination for Bankruptcy: Myth

Termination on bankruptcy or insolvency clauses are standard in most contracts. When one party faces bankruptcy or insolvency, the other party can terminate the contract. But are those provisions enforceable? DLA Piper partner Rachel Albanese explains why the Bankruptcy Code rejects such language, the rationale behind their invalidation, and a few exceptions to the rule. Rachel Albanese is a Restructuring partner at DLA Piper. ► http://www.talksonlaw.com for more legal explainers and interviews with the titans of law. ► Facebook: http://www.facebook.com/talksonlaw ► Instagram: http://www.instagram.com/talksonlaw ► Twitter: http://www.twitter.com/talksonlaw ____________________ TRANSCRIPT Joel Cohen (JC): In contract negotiations, attorneys regularly demand a termination right where the other party is facing insolvency or bankruptcy. As common as these provisions are, we were surprised to learn that they’re broadly unenforceable. Hello, and welcome to TalksOnLaw. I’m Joel Cohen. We’re joined remotely today by Rachel Albanese, a bankruptcy partner at the global law firm DLA Piper. Rachel, welcome to TalksOnLaw. Rachel Albanese (RA): Thank you. JC: Before we go on, what I said in the introduction, these provisions, they’re everywhere. Are they actually unenforceable? RA: Yeah, it’s surprising, but those provisions are generally unenforceable. JC: Maybe we can start with, what does the basic language in a contract look like for one of these termination rights? RA: It says that upon a party’s insolvency or bankruptcy or similar proceeding, that the other party can terminate the contract. JC: What is the law trying to accomplish by interfering with individuals’ abilities to negotiate? RA: It goes to the creation of the bankruptcy estate upon a debtor’s filing for bankruptcy. So once a debtor files for bankruptcy, it creates an estate, and all of the debtor’s property belongs to that estate. The goal of Chapter 11 is to rehabilitate the debtor, and the debtor needs its property to accomplish that goal. So upon the filing, Congress has said that there’s an automatic imposition of a stay of creditor action against the debtor and its property, and we call that the automatic stay. JC: What’s the purpose for the automatic stay? RA: The automatic stay is meant to prevent what we call a “race to the courthouse.” And that is to ensure that all similarly situated creditors get treated equally with respect to the priority of their claims against the debtor. And so it essentially ensures equal treatment of creditors; It gives the debtors a breathing spell, which is very important, and oftentimes one of the primary reasons for a filing. JC: The stay slows everything down. Is that also what invalidates these termination rights? RA: There’s a separate provision of the bankruptcy code, 365e, which prohibits a counter party from terminating a contract simply because of a debtor’s bankruptcy or insolvency. JC: Rachel, are there any exceptions where these termination rights can actually be enforced? RA: Yes, there are a handful of exceptions. One is where applicable non-bankruptcy law permits it, one is if it’s a contract to make a loan or a financial accommodation, and one is, for example, with complex financial contracts such as hedges, derivatives, forward contracts and the like. JC: So these provisions are largely unenforceable. You mentioned some exceptions. Why are they still being drafted in contract over contract? RA: That’s a good question. I think it’s partly because this provision is a standard provision in many contracts and lawyers may be reluctant to alter the form of the precedent, but also potentially because it may be enforceable outside of a bankruptcy proceeding. JC: So before we let you go, advice to those who are reviewing their contracts and wondering if their termination rights are in fact enforceable. RA: Well, first I would say call a bankruptcy lawyer. But the default assumption should be that the contract termination right is not enforceable upon a counterparty’s bankruptcy or insolvency. JC: Rachel Albanese, thank you for joining us today and explaining this myth of a termination right where the other party is facing insolvency or bankruptcy. RA: Thank you, it was my pleasure to join you at TalksOnLaw.