Terminable-at-Will Clauses and Executory Contracts in Bankruptcy: An Examination of Third Circuit Treatment and Practitioner Guidance

Brett Buterick
Thursday, January 22, 2015

I. Introduction 

            In the landscape of terminable-at-will provisions of executory contracts in Third Circuit bankruptcy cases, the practitioner is left in the pasture of statutory interpretation with no shepherd. While the Code expressly prohibits post-petition unilateral termination of an executory contract on the basis of an ipso facto clause, or a clause that conditions the termination of an executory contract upon a debtor’s bankruptcy, it is silent on the issue of terminable-at-will provisions.[1] This seemingly innocuous absence has far reaching consequences. A creditor can easily use a terminable-at-will provision to circumvent Congress’s intent to prohibit cancellation of a contract that may be necessary to a debtor’s rehabilitation.  At present, bankruptcy courts within the Third Circuit have not addressed the application of such clauses in bankruptcy cases, leaving contracting parties, debtors, creditors, and the attorneys who represent them stumbling in the dark.  

            This article serves two purposes. First, it will provide a cursory overview of terminable-at-will provisions of executory contracts in bankruptcy, as well as directional guidance for how a Third Circuit bankruptcy court will likely treat unilateral dissolution of an executory contract predicated upon a terminable-at-will provision. Second, this article will advocate certain practical positions for contracting parties when dealing with terminable-at-will provisions.

II. Treatment of Terminable-at-Will Provisions

            Section 365(e) expressly prohibits the termination of a contract after the commencement of a bankruptcy proceeding on the basis of an ipso facto or similar bankruptcy termination clause.[2] This section was added to the 1978 Bankruptcy Code after Congress acknowledged that the enforcement of such clauses “frequently hamper[] rehabilitation efforts [of debtors].”[3] Given the language of §365(e) and Congress’s policy justification for the prohibition, it seems a provision that achieves the same goal as an ipso facto clause should similarly be prohibited.

            Again, however, the Code does not expressly prohibit unilateral dissolution of executory contracts, post-petition, on the basis of a terminable-at-will provision. Not only is the Code silent on the issue, but so too are courts within the Third Circuit. In fact, few courts across the nation have examined the permissibility of such terminations; however the courts that have agree the terminations are prohibited by the §365(e) proscription of ipso facto clauses.[4]

            Courts addressing the issue cite two reasons for extending the § 365(e) prohibition to these clauses. First, their enforcement would “violate the Congressional policy undergirding 11 U.S.C. §365(e)(1).”[5] Second, when a commercial relationship exists between contracting parties, cancellation of a contract must comply with the common law duty of good faith, and to cancel a contract “in violation of an express congressional enactment is not a good faith exercise of a ‘terminable at will’ provision.”[6]

            In In re Ernie Haire Ford, Inc., the debtor, an automobile dealer, had a contractual relationship with several third party auto finance companies.[7] Each contract included a provision allowing either the debtor or the financier to terminate the agreement at any time, upon a certain number of days notice.[8] After the debtor filed its Chapter 11 case, each of the financing companies unilaterally terminated their contracts with the debtor.[9] The court reasoned that the termination of contracts based solely on the filing of a petition for Chapter 11 reorganization was “in clear contravention of the express congressional intent behind § 365(e)(2).”[10] The court further reasoned that since the termination was a contravention of express congressional policy, the financing companies violated the common law implied covenant of good faith and fair dealing.[11] Accordingly, the agreements between the debtor and the financing companies were to remain in effect pending the debtor’s final acceptance or rejection of the agreement.[12]

            Given the strong sentiment against ipso facto clauses and the ever broadening definitions of these clauses within Third Circuit bankruptcy courts, it is almost certain these courts will prohibit post-petition, unilateral termination of an executory contract on the basis of a terminable at will provision when faced with the issue. As the US Bankruptcy Court, District of Delaware noted, “[t]oday courts continue to read the Code's ipso facto sections broadly to effectuate code policy and in recognition that bankruptcy matters are also inherently proceedings in equity.”[13] Liberal interpretations of the Code provision have only continued as evidenced by one court’s expansion of the provision beyond actions based upon §§ 541(c) and 365(e). [14]

III. Conclusions and Suggestions

            Nonetheless, automatic stay treatment of terminable-at-will provisions should have no real effect on contracting parties during the drafting process. In fact, Collier on Bankruptcy implies the same with regard to ipso facto clauses by advocating continued inclusion of these provisions in contracts.[15] Collier cites as support for inclusion the protection such clauses afford the garden-variety of other insolvency events that may not render termination unenforceable.[16] The same justification is even more applicable to terminable-at-will provisions because of their broad and sweeping nature. Whereas termination of an executory contract on the basis of an ipso facto clause is conditionally predicated upon some insolvency event, dissolving a contract on the basis of a terminable-at-will provision requires no such condition, thus allowing for a wider array of non-bankruptcy related events to be covered. Therefore, short of not entering into a contract with every party that has some remote chance of insolvency, contracting parties have few preventative measures at their disposal to avoid default.

[1] See 11 U.S.C.A. § 365(e) (West 2012).

[2] 11 U.S.C.A. § 365(e) (West 2012).

[3] S.Rep No. 95-989, at 59 (95th Cong., 2d Sess.1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5845; H.R.Rep. No. 95-595, at 348 (95th Cong., 1st Sess.1977), reprinted in 1978 U.S.C.C.A.N. 5787, 6304.

[4] See In re Ernie Haire Ford, Inc., 403 B.R. 750, 759 (Bankr. M.D. Fla. 2009); see also In re B. Siegel Co., 51 B.R. 159, 161 (Bankr. E.D. Mich. 1985); In re Nat’l Hydro-Vac Indus. Serv., L.L.C., 262 B.R. 781, 786 (Bankr. E.D. Ark. 2001).

[5] In re Nat’l Hydro-Vac Indus. Serv., L.L.C., 262 B.R. at 786.

[6] In re B. Siegel Co., 51 B.R. at 164.  

[7] 403 B.R. at 753.

[8] Id. at 754.

[9] Id.

[10] Id. at 759.

[11] Id.

[12] See also In re Nat’l Hydro-Vac Indus. Serv., L.L.C., 262 B.R. at 784 (holding that the unilateral termination of a contract violated the automatic stay because the at-will termination upon the debtor filing bankruptcy would undermine congressional policy behind prohibiting ipso facto clauses and “at least raise[] the inference of bad faith”); In re B. Siegel Co., 51 B.R. 159 (rejecting the contracting party’s pretext reasons for termination and holding that the termination violated the automatic stay).

[13] In re Railway Reorganization Estate, Inc., 133 B.R. 578, 583 (Bankr. D. Del.1991)

[14] In re W.R. Grace & Co.475 B.R. 34, 154 (D. Del.), appeal dismissed (Sept. 24, 2012), appeal dismissed (Oct. 4, 2012), appeal dismissed (Oct. 9, 2012), aff'd (July 24, 2013), appeal dismissed (Sept. 4, 2013), appeal dismissed (Feb. 3, 2014), appeal dismissed (Feb. 3, 2014), appeal dismissed (Feb. 3, 2014), motion for relief from judgment denied,476 B.R. 114 (D. Del. 2012) and aff'd sub nom. In re WR Grace & Co., 729 F.3d 332 (3d Cir. 2013) and aff'd, 532 F. App'x 264 (3d Cir. 2013) and aff'd, 729 F.3d 311 (3d Cir. 2013) and aff'd sub nom. In re WR Grace & Co., 729 F.3d 332 (3d Cir. 2013)

[15] 4-68 Collier Bankruptcy Practice Guide P 68.12.

[16] Id. These include assignments for the benefit of creditors, and appointment of a receiver. Id.