Ipso Facto Contract Provision Not Enforced

By:  Kayla Martin

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In March of 2017, a United States Bankruptcy Court for the Eastern District of Washington held that shareholders of a corporation were not entitled to relief from the automatic stay[1] to exercise their contractual right to buy back a debtor’s shares.[2]  Softbase Development’s four shareholders entered into an agreement containing several termination events that would result in an option for non-terminating shareholders to buy back shares.[3]  A shareholder filing for bankruptcy was such a termination event.[4]  In March of 2015, Eustler, an employee and shareholder of Softbase Development, filed for bankruptcy.[5]  Upon learning of Eustler’s bankruptcy, two of the remaining shareholders exercised their right to purchase Eustler’s shares.[6]  Those shareholders moved for relief from the automatic stay to exercise their option, asserting that, under their agreement, Eustler’s shares were not part of his bankruptcy estate.[7]  Ultimately, the court found the termination provision in the agreement unenforceable pursuant to sections 541(c)(1)(B) and 365(e)(1) of the Bankruptcy Code, because its terms were dependent on the debtor’s financial condition.[8]

Sections 365(e)(1) and 541(c)(1)(B) of the Bankruptcy Code protect debtors, such as Eustler, from ipso facto contractual provisions that terminate a debtor’s interest in property merely because a bankruptcy is filed.[9]  In such situations, a bankruptcy court’s first step is determining whether an agreement is executory.[10]  Although the Bankruptcy Code does not define “executory,” the “Countryman” Test, as applied in Eustler, defines a contract as executory when contract obligations are so unperformed that failure to complete those obligations constitutes a material breach.[11]  Looking to state contract law, the Eustler court found the restrictive covenants “not sufficiently material to render the agreement executory.”[12]  Conversely, if the agreement was executory, it would have been enforced, unless it fell under section 365’s exception.[13]  Under the exception, notwithstanding agreements to the contrary, contractual provisions contingent on a debtor’s insolvency or financial condition cannot terminate the debtor’s rights or obligations.[14]  Such provisions “that prevent the bankruptcy estate from receiving the benefit of an executory contract” will be unenforceable.[15]             

Section 541(c)(1)(B) deems all legal or equitable interests in property part of the debtor’s estate regardless of agreements “that [are] conditioned on the insolvency or financial condition of the debtor . . . and gives an option to effect . . . termination of the debtor’s interest in property.”[16]  Thus, similar to section 365(e)(1), section 541(c)(1)(B) renders such agreements unenforceable.[17]  The court found Softbase Development’s agreement unenforceable pursuant to section 541(c)(1)(B) because it terminated Eustler’s stock interest in the company through an option right simply because Eustler filed for bankruptcy.[18]

As the court emphasized, requiring the preservation of equitable interests in lieu of bankruptcy ensures that the debtor will have the opportunity to make the payments proposed under the chapter 13 plan.[19]  If Eustler’s shares were bought by the complaining shareholders, they would become majority shareholder owners, ultimately putting Eustler’s employment at risk.[20]  Eustler’s continued employment is essential for him to make payments to creditors in accordance with his chapter 13 plan.[21]  Ultimately, the court’s decision, along with sections 541(c)(1)(B) and 365(e)(1) of the Bankruptcy Code, protects the interests of creditors.[22]

[1] In re Eustler, No. 15-00870-FPC13, 2017 WL 1157114, at *4 (Bankr. E.D. Wash. Mar. 24, 2017).

[2] Id. at 1.

[3] Id.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id. at *4.

[9] In re Eustler, 2017 WL 1157114, at *4.  While, section 365(e)(1) is an exception applying specifically to conditions in executory contracts, section 541(c)(1)(B) more broadly applies to a provision in any agreement, transfer instrument, or applicable bankruptcy law.  See 11 U.S.C. § 365(e)(1) (2012); 11 U.S.C. § 541(c)(1)(B) (2012).

[10] In re Warner, 480 B.R. 641, 648 (Bankr. N.D. W. Va. 2012).

[11] In re Eustler, 2017 WL 1157114, at *2; See, E.g., In re Warner, 480 B.R. at 650; In re Dixie Management & Investment, LP, 474 B.R. 698, 700 (Bankr. W.D. Ark. 2011) (explaining majority of courts apply the Countrymen Test to define executory contracts); Pacific Express, Inc. v. Teknekron Infoswitch Corp. (In re Pacific Express, Inc.), 780 F.2d 1482, 1487 (9th Cir. 1986).

[12] In re Eustler, 2017 WL 1157114, at *2–3 (explaining that since the agreement formed in Texas, applying Texas state contract law is appropriate).  Though it is not clear whether applying state law is a majority rule, the Eustler court relied on a footnote from In re Cochise College Park.  There, the court explained that while determining whether an agreement is executory is a matter of federal law, “the question of legal consequences of one party’s failure to perform . . . under a contract is an issue of state contract law.”  Hall v. Perry (In re Cochise College Park, Inc.), 703 F.2d 1339, 1348 n.4 (9th Cir. 1983). 

[13] 11 U.S.C. § 365(a) (2012) (section 365(a) allows a trustee to either “assume or reject any executory contract . . . . of the debtor”); In re Warner, 480 B.R. at 649 (stating once an agreement is considered executory, all of section 365 applies subjecting the agreement to two important exceptions, one being in section 365(e)(1)). 

[14] 11 U.S.C. § 365(e)(1).

[15] In re Warner, 480 B.R. at 649–50.

[16] 11 U.S.C. § 541(c)(1)(B); H.R. Rep. No. 95-595, at 367 (1977).

[17] 11 U.S.C. § 541(c)(1)(B); H.R. Rep. No. 95-595, at 369.

[18] In re Eustler, 2017 WL 1157114, at *4.  

[19] Id.

[20] Id.

[21] Id.

[22] See, In re Eustler, 2017 WL 1157114, at *4; In re Warner, 480 B.R. at 648–49 (explaining how executory contracts permit state contract law restrictions on the trustee’s rights and non-executory contracts render restrictions unenforceable against a trustee).