When reviewing documents used in asset protection planning by other planners, I always find it amusing to see long clauses that claim to do this, that and the other in the event the client becomes insolvent or falls. bankrupt. Most often, these clauses are intended to deprive the client of ownership of an entity in the event that a significant creditor arises. A typical clause would read like this:
“In the event that Joe becomes insolvent or business is initiated for Joe in bankruptcy, Joe’s interest in ABC LLC will terminate immediately.”
When writing, most of these clauses are much longer and some planners seem to spend a lot of time working them out towards what they consider to be perfection. I have seen these clauses not only a few times spanning more than one page. The assumption is that if the customer gets into trouble, this clause will apply to protect the affected asset from creditors. But do these clauses work in real life?
The first thing to understand is that these clauses generally do not work in bankruptcy as they are specifically neutralized by the Bankruptcy Code itself. In this forum, these clauses are called Ipso Facto clauses and are addressed by 11 USC § 365 (e) (1), which provides:
“(1) Notwithstanding any provision of an enforceable contract or unexpired lease, or applicable law, an enforceable contract or unexpired lease of the debtor may not be terminated or amended, and no right or obligation under of this contract or lease may not be terminated or amended at any time after the commencement of the matter solely because of a provision of such contract or lease which is conditional on: (A) the insolvency or the situation debtor at any time before the closing of the matter; (B) the opening of a matter under this Title; or (C) the appointment or taking of possession by a Trustee in a matter under this security or a depositary before this opening. “
Although there are legal exceptions to § 365 (e) (2), these have very limited application and therefore we will review in this article. What is important are clauses (A) and (B) which prohibit a contract (and only an “enforceable contract”) or an unexpired lease from being terminated or amended simply because the debtor has become insolvent or has went bankrupt.
In the most common bankruptcy usage for personal bankruptcies, these clauses prohibit the termination of a mortgage, rental agreement, or things like car leases because the debtor has declared bankruptcy. But they can also play a role in asset protection planning.
For example, suppose the debtor is a member of a limited liability company. The LLC’s operating agreement provides that if a member becomes insolvent or bankrupt, then the member is dispossessed of its stake. In most cases, § 365 (e) (1) will prohibit other members from evicting the debtor from the LLC if the debtor becomes insolvent or goes bankrupt (voluntarily or involuntarily).
It should be noted here that even where non-debtor parties – like other members of our hypothetical LLC – have a contractual right to attempt to part with the debtor of its assets, the mere attempt of these non-debtor parties to do so may to be considered as violating the automatic stay of the bankruptcy court, and thus subject these parties to the contempt and the financial penalties resulting therefrom. Extreme caution is therefore required in attempting to take advantage of such clauses.
Apart from bankruptcy, the creditor’s remedy is usually found in the Uniform Voidable Transactions Act (UVTA) or otherwise in the Fraudulent Transfer Act. The creditor’s challenge will almost always be primarily based on the intent test of § 5 (a), which has only two elements: (1) the debtor was insolvent at the time of the transfer, and (b) the transfer was not not a reasonably equivalent value.
Because such a clause only comes into effect when the debtor is insolvent or bankrupt, the first element will be easily satisfied. Especially when the debtor is simply dispossessed of an asset, the second element will also be easy for a creditor to satisfy. Where it becomes more difficult for a creditor is when there is a repurchase of the asset, depending on whether or not the asset rises to a level of a reasonably equivalent value, but frankly the Most creditors would prefer to have the money from a buyout even if it is not particularly close to the value of the asset.
It is therefore in this non-bankruptcy situation that Ipso Facto clauses could work if they were cleverly drafted, but few of them really do, despite their often verbose nature. The problem is, planners focus on getting creditors to get nothing, which is more likely to lead to failure, than giving creditors Something which is less than the value of the asset but which the creditor may be willing to accept and simply move on.
Of course, this is also a typical flaw of many asset protection plans in general.