• Note Provision Accelerating Debt Upon Bankruptcy Filing Was Not Invalid Ipso Facto Clause
  • November 7, 2013 | Authors: Elizabeth J. Austin; Irve J. Goldman; Jessica Grossarth; Jonathan A. Kaplan
  • Law Firms: Pullman & Comley, LLC - Stamford Office ; Pullman & Comley, LLC - Bridgeport Office ; Pullman & Comley, LLC - Hartford Office
  • An ipso facto clause is a provision in a contract or other written instrument which eliminates or limits the property or contract rights of a party upon its insolvency or filing of bankruptcy. See 11 U.S.C. §§363(l), 365(b)(2), 541(c)(1)(B).

    In EETC v. AMR Corporation (In re AMR Corporation), 2013 WL 4840574 (2d Cir. Sept. 12, 2013), secured notes provided by American Airlines (“AA”) to finance a collection of aircraft contained ipso facto clauses which automatically accelerated the note indebtedness upon a bankruptcy filing. The notes also provided for the payment of a “Make-Whole Amount” in the event of a voluntary redemption prior to maturity, but exempted its payment in the event of debt acceleration due to bankruptcy. The Make-Whole Amount was defined as the present value of the remaining scheduled payments of principal and interest to maturity using a discount rate linked to the U.S. Treasury rate of interest.

    On November 29, 2011, AA filed a voluntary Chapter 11 petition and shortly thereafter made elections under section 1110(a) of the Bankruptcy Code to perform all obligations under the notes and to cure any default other than a default of a kind specific in section 365(b)(2) (nullifying ipso facto clauses in executory contracts). The elections confirmed that they did not constitute assumptions of the underlying financing agreements. Under section 1110(a), a debtor must make such a timely election in order to keep the automatic stay in effect for aircraft pledged as collateral for a debt.

    Later in the Chapter 11 proceeding, AA sought to refinance the note indebtedness without paying the Make-Whole Amount. U.S. Bank, the trustee of the notes, objected, arguing that the automatic acceleration of debt pursuant to the ipso facto clauses was unenforceable pursuant to 11 U.S.C. §§363(l), 365(b)(2) and 541(c)(2)(B) and that even if enforceable, the §1110(a) elections de-accelerated the debt, making the refinancing of the note indebtedness a voluntary redemption prior to maturity. As a result, maintained U.S. Bank, the Make-Whole Amount had to be paid.

    The bankruptcy court and district court on appeal rejected these arguments and the Second Circuit affirmed. The Second Circuit ruled that the ipso facto clauses in the notes were enforceable since the applicable Bankruptcy Code provisions that nullify ipso facto clauses did not apply to promissory notes or trust indentures. In particular, the Second Circuit reasoned that while section 365(b)(2) nullifies ipso facto clauses in executory contracts, a note is not an executory contract. The other Bankruptcy Code sections implicated -- §§541(c)(1)(B) and 363(l) - also were held not to apply because they only protect property that otherwise would become property of the estate or the use of such property from forfeiture, whereas the debt acceleration clause at issue did not prevent property from becoming property of the estate or the use of property by the estate.

    The Second Circuit also held that the note indebtedness was not de-accelerated by AA’s §1110(a) elections because such elections merely establish an interim arrangement for compliance with debt obligations secured by aircraft in order to maintain the automatic stay in effect, and do not constitute assumptions of the underlying financing agreement. Although section 1110(a) requires a cure of defaults, other than a default of a kind specified in section 365(b)(2), AA’s default giving rise to an acceleration of debt - which was its bankruptcy filing - was of the kind specified in section 365(b)(2) even though it was contained in a note that was not an executory contract.