August 2012 Bar Bulletin
 
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August 2012 Bar Bulletin

Ipso Facto Clauses: Ninth Circuit Bankruptcy Law in Flux

By Christina Latta Henry and Jacob DeGraaff

 

Ipso facto (Latin for "by the fact itself") clauses in contractual and lease agreements are intended to trigger default in the event the signer files for bankruptcy protection or becomes insolvent, allowing the creditor to terminate a lease or ursue other remedies. In theory, by filing a bankruptcy, the debtor is, ipso facto, defaulting on his or her obligations - hence the name.

Provisions of 11 U.S.C. 365 of the Bankruptcy Code generally render these clauses unenforceable, in an effort to prevent parties from using cleverly written contracts to undermine the bankruptcy process.1 In In re Dumont,2 the Ninth Circuit ruled that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) allowed a creditor to enforce an ipso facto clause against a debtor who had failed to reaffirm a debt on her vehicle. A review of other pertinent case law in the circuit, however, suggests that Dumont has not codified the ipso facto clause as completely as many attorneys have thought.

Background

Liens against real property, like a house or a car, survive the bankruptcy process unless they are specifically avoided, or removed, by the bankruptcy court. The debtor's personal liability on the debt is eliminated upon discharge, but the lien remains, and the creditor may repossess the asset to recover some of its losses. If the asset is worth less than the debt, the creditor cannot attempt to collect the difference from the debtor.

In many cases, therefore, it's in the best interest of both parties for the debtor to continue making normal payments on the secured loan through the bankruptcy process and after discharge until the debt is fully paid - the debtor gets to keep the asset and the creditor gets paid in full as originally agreed to. This is colloquially known as the "ride-through" option: the secured loan is carried through the bankruptcy and resolved normally afterward.

Unfortunately, debtors aren't always able to make the payments, which may lead the creditor to repossess or foreclose to obtain the asset or sue on the contract in the case of a lease. Because the debt was included in the bankruptcy, the creditor's recourse is limited to the asset itself. This means that a creditor may incur a large loss if the asset, lease or executory contract is worth significantly less than the remaining debt owed.

The ipso facto clause is an effort on the part of the creditor to avoid being a part of an insolvency or bankruptcy process to begin with, by triggering a default if the debtor files and thereby allowing collection efforts to be handled outside bankruptcy. BAPCPA did not repeal the part of the Bankruptcy Code that makes such clauses unenforceable against the debtor, but in introducing new provisions designed to eliminate the ride-through option for personal property, it seemed to allow ipso facto in through the back door.

Ride-through Hits a Roadblock


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