Ipso facto clause

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USA: Ipso facto clauses and the Bankruptcy Code

In America, an ipso facto clause is one that allows one party terminate a contract, accelerate payments under it, or somehow get an unconscionable jump on the other party, if that unfortunate other party goes bankrupt. These are generally invalid under the Bankruptcy Code because an insolvency trustee is not bound by any provision that is conditioned on the debtor's insolvency.

11 USC §365(e)(i) states:

Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title; or

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

Relevant in an ISDA Master Agreement because while the standard Bankruptcy Event of Default itself doesn’t offend the rule, arguably Section 2(a)(iii), which allows you and Event of Default to not close out the other guy, and instead just cease paying what you owe him on the ISDA until he magically becomes unbankrupt, whereupon you would have to start paying again.

Example: the flip clause in a synthetic CDO

In Lehman Brothers Financing v BNY Corporate Trustee Services Limited the US Bankruptcy Court held a “flip” clause in one of Lehman’s synthetic CDOs was an unenforceable ipso facto clause. Here the flip clause that inverted the priority of creditors — ordinarily, a swap counterparty ranks ahead of noteholders in a credit-linked note, which figures, since the economic point of the deal is for the noteholder to sell credit protection to the swap counterparty — so that CDO noteholders would rank ahead of the Lehman swap counterparty if Lehman defaulted under its swap with the CDO issuer.

UK: the anti-deprivation principle

In the United Kingdom, there is no statutory equivalent of America’s ipso facto rule, but resourceful common law judges invented the “anti‑deprivation rule”: that, in the honeyed words of Sir William Page Wood V.C., in Whitmore v Mason (1861) 2J&H 204:

“no person possessed of property can reserve that property to himself until he shall become bankrupt, and then provide that, in the event of his becoming bankrupt, it shall pass to another and not his creditors”.

This required some wilfulness on the bankrupt’s part and not just inadvertence or lucky hap, but if you intend to defeat the standing bankruptcy laws you will not get away with it. Voidable preference laws, defeating hastily-contrived security interests over the assets of a sinking merchant, do much the same thing.

To this commentator, this feels quite a long way away from exercising a bankruptcy Event of Default under a master trading agreement, and so it has generally been regarded, until the global pandemic prompted some hasty and ill-thought out legislative proposals in the spring of 2020.

It seems, at any rate, that the ISDA Master Agreement’s Section 2(a)(iii), which allows a party a positive windfall in the event of the oppo’s insolvency (in that it can suspend its own performance, but still insist on performance from the defaulting counterparty) might resemble some kind of intended deprivation; merely crystallising ones existing position and stopping it getting further down the Swanee, as one might do by closing out your ISDA Master Agreement altogether, seems less so.

See also

• Section 2(a)(iii) of the ISDA Master Agreement.