Protecting Commercial Agreements from The Impact of Bankruptcy

In a volatile economic environment marked by shifting regulatory pressures, high interest rates, and supply chain adjustments, corporate counterparties face heightened insolvency risks. When a commercial contract counterparty files for Chapter 11 bankruptcy, rights and obligations change instantaneously under federal bankruptcy law.

The automatic stay under Section 362 of the Bankruptcy Code prohibits creditors from taking immediate enforcement actions, terminating contracts, or seeking setoffs without bankruptcy court authorization. Furthermore, under Section 365, the debtor or bankruptcy trustee possesses the statutory right to assume, reject, or assign executory contracts.

To protect business operations and minimize monetary exposure prior to a bankruptcy filing, counterparties should consider four key structural protections during contract drafting:

1. Clear Ipso Facto Clause Accompanied by Performance Default Triggers: While ipso facto clauses that terminate contracts solely due to bankruptcy are generally unenforceable under Section 365(e), default provisions tied to concrete operational metrics or financial covenants provide actionable non-bankruptcy grounds for default.

2. Robust Cash Collateral and Letters of Credit: Credit enhancements such as irrevocable letters of credit issued by third-party financial institutions are generally excluded from the debtor's bankruptcy estate property, enabling immediate draws without violating the automatic stay.

3. Reciprocal Netting and Setoff Agreements: Structuring master agreements with express contractual netting and setoff provisions preserves critical remedies under Section 553 of the Bankruptcy Code.

4. Upstream Guaranties and Escrow Controls: Securing parent corporate guaranties or establishing third-party escrow arrangements ensures secondary recovery channels independent of the primary obligor's bankruptcy proceeding.

Proactive contract structuring combined with early legal evaluation upon the first signals of financial distress remains the most effective defense against counterparty insolvency loss.