The Enforceability of Ipso Facto Provisions in a Dismissed Chapter 11 Case
Section 365 of the U.S. Bankruptcy Code does not address the legal status of an executory contract that is not assumed or rejected in a chapter 11 proceeding. In such cases where a chapter 11 plan is confirmed, courts adopt the ride through doctrine as a judge-made solution. Pursuant the doctrine, such contract rides through unaffected by the bankruptcy case and remains an enforceable contract among the reorganized debtor and the non-debtor counterparty.
The status of ipso facto clauses in a dismissed case appears to be a question of first impression. One scenario involving these questions has been addressed recently by the Connecticut Supreme Court in CCT Communications, Inc. v. Zone Telecom, Inc., Case No. SC 19574, Nov. 21, 2017. In reversing the lower court, the Court held that (i) the ride through doctrine does not apply to dismissed cases and (ii) the ipso facto prohibition retains its vitality even if the case is dismissed, such that a post-petition notice of termination had no force and effect.
Background
While there is much to the factual background of CCT Communications, for purposes of this alert, the relevant facts are straightforward. CCT Communications, Inc. (“CCT”) and Zone Telecom, Inc. (“Zone”) were parties to a purchase agreement whereby Zone purchased from CCT long distance telephone services and a circuit to place such calls through a third party’s (Global Crossing Telecommunications, Inc. (“Global”)) long distance service network. In essence, CCT acted as a middle man, buying Global’s services and reselling them to Zone. The agreement included a classic ipso facto clause, providing that the agreement could be terminated by either party should the other party file for bankruptcy.
CCT filed for bankruptcy in January 2007 and in February 2007, Zone sent a letter to CCT exercising its right to terminate the agreement because of CCT’s bankruptcy filing. In November 2009, the bankruptcy court dismissed CCT’s bankruptcy petition because CCT failed to timely confirm a plan. CCT then filed an action in Connecticut state court, claiming breach of the Agreement by Zone, mainly due to Zone’s failure to pay CCT under the terms of the contract. Zone filed counterclaims alleging that CCT breached the contract by failing to provide the services required and by filing for bankruptcy. The trial court held that CCT breached the contract and awarded Zone damages. CCT appealed.
Analysis
Section 365(e)(1) of the Bankruptcy Code provides that an executory contract of a debtor may not be terminated solely because of a provision in such contract that is conditioned on, among other things, a bankruptcy filing (the ipso facto provision). There are, however, certain exceptions to the ipso facto provision of the Bankruptcy Code. In analyzing such exceptions, the trial court found that (i) the ride through doctrine was applicable as CCT never expressly assumed or rejected the agreement prior to the bankruptcy dismissal, and (ii) Zone’s purported termination became valid upon dismissal of CCT’s petition.
The Connecticut Supreme Court reversed. The Connecticut Supreme Court found that the ride through doctrine did not apply in this case, because its survey of bankruptcy case law indicated that the doctrine has been applied only in cases where chapter 11 plans were confirmed. Rather, section 349(b)(3) of the Bankruptcy Code governs, which upon dismissal, automatically revests the property of the estate, including contract rights, in the debtor. Still, section 349 does not answer the question at hand—the enforceability of ipso facto clauses in dismissed cases.
Nevertheless, the court went on to hold that even if the ride through doctrine was applicable, the doctrine does not create an exception to section 365(e)(1). In so holding, the Supreme Court rejected two theories adopted by the trial court: (i) a debtor may not avail itself of any protection of section 365 until it expressly assumes an executory contract and (ii) a purported termination initiated during the bankruptcy is effective nunc pro tunc upon the dismissal of the petition. We address each of these theories below.
First, the Supreme Court held that the ipso facto prohibition is enforceable in the pre-assumption/rejection period. There is nothing in plain language of the Bankruptcy Code that indicates that the ipso facto protection afforded by section 365(e)(1) is available to the debtor only upon assumption. Indeed, section 365(e)(2) lists various conditions under which ispo facto does not apply, and it does not mention the need to assume for section 365(e)(1) to apply. Under section 365, chapter 11 debtors are permitted to defer the decision of assumption or rejection of executory contracts until plan confirmation. This ensures that a debtor does not have to assume a contract absent confirmation of a particular plan and provides the debtor with time and flexibility during the case to determine what contracts to assume or reject. If section 365(e)(1) does not apply until express assumption, a nondebtor party would be able to terminate the contract upon the bankruptcy filing, before a debtor has the opportunity to decide whether assumption or rejection will best serve the interests of reorganization and of its creditors.
We note that in addition, section 365 is applicable in chapter 7 cases in which most executory contracts are eventually rejected rather than assumed. In short, the trial court’s ruling in this regard is entirely inconsistent with the Bankruptcy Code.
Next, the Supreme Court held that ipso facto clauses are unenforceable during the bankruptcy case notwithstanding the eventual dismissal of the case. A notice of termination that was given during the bankruptcy case does not become effective, nunc pro tunc, upon dismissal. First, there are no cases in which a court has retroactively revived a termination in this manner. That is no wonder since under the explicit terms of section 365 of the Bankruptcy Code, ipso facto clauses are unenforceable. Second, a ruling giving effect to the post-petition termination notice would create tremendous uncertainty since the parties do not know, at time of termination, whether the case will be dismissed thus retroactively validating the termination. Third, the proposition is based on incongruous reasoning – one cannot argue that an agreement is unaffected as if the bankruptcy never occurred, yet terminate it on the basis of a bankruptcy filing.
Finally, while mentioned by the Supreme Court only in passing, a post-petition termination of a contract is subject to the automatic stay and acts taken in violation of the stay are void. Thus, Zone’s termination was void and the lower court provided no basis for the resurrection of a void act.
Conclusion
While CCT Communications was issued by a state court, its significance should not be understated. It addresses a novel bankruptcy issue on which there is little direct guidance from the bankruptcy courts. As such, we expect it to play a guiding role as case law on the subject further develops.
