Tinkering With Ipso Facto Provisions In Financial Contracts Could Send Them Sailing Out of Safe Harbors

Contributed by Maurice Horwitz
The scope of the Bankruptcy Code’s safe harbor for certain financial contracts has been tested again, this time in the United States Bankruptcy Court for the Western District of Louisiana.  The question this time was whether an ipso facto provision continues to be safe harbored if enforcement of that provision is conditioned on other factors – in this case, the debtor’s failure to perform under the contract. 
Consistent with prior case law, the court held that termination is only safe harbored if it is based solely on a condition specified in 365(e)(1), i.e., the financial condition of the debtor, bankruptcy, or the appointment of a trustee.  Because the ipso facto provision in this case contained an additional condition to enforcement (the debtor’s breach), it no longer fell within the safe harbor.  Thus, even if both conditions were satisfied (bankruptcy and breach), the automatic stay applied and the termination clause could not be exercised absent relief from the automatic stay.
The debtor in In re Louisiana Pellets, Inc. was part a corporate group that processes raw wood into specialized pellets for use as fuel in power plants and heating systems.  The debtor was a party to a Sale and Purchase Agreement with a counterparty that uses wood pellets to fuel and operate a power generator.  The Sale and Purchase Agreement provided for multiple shipments of wood pellets by the debtor to the counterparty over a period of five years.
By the time that the debtor filed its chapter 11 case, the counterparty wanted out of the contract.  The counterparty had ceased operating the generators that relied on wood pellets for fuel, and in addition, the market price for wood pellets had declined during the period after the parties entered into the Sale and Purchase Agreement.
The Sale and Purchase Agreement contained a standard ipso facto provision that permitted either party to terminate the agreement upon the occurrence of certain events of default, including the commencement of a bankruptcy case by the other party.  Wishing to exercise this termination right, the counterparty filed a motion asking the Bankruptcy Court to confirm that the Sale and Purchase Agreement falls within the Bankruptcy Code’s safe harbor and that, accordingly, the automatic stay did not bar the counterparty’s termination of the contract.
The general rule in bankruptcy is that such ipso facto provisions are not enforceable.  Section 365(e)(1) of the Bankruptcy Code prohibits a non-debtor counterparty from terminating an executory contract with the debtor “solely because of a provision in such contract…that is conditioned on” one of three conditions: (1) “the insolvency or financial condition of the debtor,” (2) “the commencement of a case under [the Bankruptcy Code],” or (3) “the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.”  But the Bankruptcy Code also provides certain “safe harbors” from this prohibition for certain types of contracts, meaning that ipso facto provisions are enforceable under those specific types of contracts.  Section 556, for example, creates a safe harbor exception to Section 365(e)(1) for certain types of commodity contracts, including “forward contracts” with “forward contract merchants,” and permits a party to enforce a termination right that is based on a “condition of the kind specified in Section 365(e)(1).”
In Louisiana Pellets, it was undisputed that the Sale and Purchase Agreement demonstrated the characteristics of a “forward contract” and that the non-debtor counterparty was a “forward contract merchant,” as those terms are defined by the Bankruptcy Code.  However, the ipso facto provision that the counterparty relied upon had been modified by a later amendment, pursuant to which the counterparty agreed to

not terminate the [agreement] if [the debtor] files or initiates proceedings or has proceedings filed or initiated against it relating to its liquidation, insolvency, reorganization or other relief under any bankruptcy, insolvency or other similar law so long as [the counterparty] is being paid all amounts required to be paid to it under the terms of the [agreement and the debtor] is otherwise fully performing its obligations under the [agreement], including, without limitation, the delivery of fully compliant product.

In other words, the ipso facto provision could only be invoked by the counterparty if the debtor, in addition to commencing a bankruptcy case, was also in breach of its obligations under the Sale and Purchase Agreement.  The counterparty alleged that the debtor had breached certain provisions of the agreement and tendered non-conforming wood pellets, such that two requirements of the ipso facto provision – bankruptcy and breach – had been satisfied.
The threshold issue for the court was whether the ipso facto provision, as modified, still fell within the safe harbor created by Section 556 of the Bankruptcy Code.  The counterparty argued that conditioning exercise of its termination right on the debtors’ failure to perform did not eliminate the protections afforded by the safe harbor.  The debtor, on the other hand, argued that because of this modification to the ipso facto provision, the counterparty could no longer terminate the Sale and Purchase Agreement “solely because of a provision in such contract…that is conditioned on…the commencement of a case under [the Bankruptcy Code.”  Termination now needed to be predicated on two factors – bankruptcy and breach.
The court held that the ipso facto provision, as modified, could no longer benefit from the Bankruptcy Code’s safe harbor.  Although the court agreed with the counterparty’s argument that the safe harbors “are generally read broadly to promote the underlying purpose of the safe harbor,” the court also noted that “courts construe the safe harbors according to their plain terms.”  And the plain terms of Section 556 only permit a non-debtor counterparty to terminate its contract with a debtor, notwithstanding the automatic stay, if the termination is based on a condition “of the kind” specified in Section 365(e)(1).  In this case, the modified ipso facto provision required the counterparty to base its termination on more than the commencement of a bankruptcy case: the counterparty also had to establish a breach by the debtor.  The court held that “[t]his [i.e., failure to perform] is not a condition ‘of the kind’ set forth in section 365(e)(1).”  So even if both conditions are satisfied (bankruptcy and breach), the automatic stay applies and the termination clause may not be exercised absent relief from the automatic stay.
The key takeaway of Louisiana Pellets is that ipso facto provisions in financial contracts should be drafted carefully so that their enforcement depends solely on one of the conditions specified in Section 365(e)(1).  If a court perceives that any other condition is required for termination, then the right to terminate may not be safe harbored, and enforcement of that provision will be subject to the automatic stay.