Contract provisions stating that either the owner or the contractor’s bankruptcy will constitute an event of default are common. A corresponding provision typically sets out the nonbreaching party’s rights in the event of default, one being the right to terminate the contract. For all practical purposes, these provisions are meaningless and unenforceable.
Section 365 of the Bankruptcy Code deals with the debtor’s right to assume or reject executory contracts. (“Executory contracts” are essentially contracts for which performance is not yet complete. A construction contract is an executory contract.) That same section also gives the debtor the right to assign such contracts. Section 365(e)(1) states that any provision in an executory contract that permits one party to terminate the contract in the event of the other’s insolvency or in the event that the other files a bankruptcy petition is unenforceable. And section 365(b)(2)(A) similarly states that any provision in an executory contract that prohibits the debtor from assuming and assigning the contract is unenforceable.
A participant at one of our recent “Financial Defaults” seminars suggested one possible reason for using such a provision. If the contract is guarantied by a third party and the guaranty obligation is triggered only by a default under the principal contract, such a provision might work to trigger the guaranty. To us that seems unnecessary, since the guaranty could be drafted to state that it is triggered by the principal’s default.
Notwithstanding section 365’s nullification of bankruptcy default provisions, they continue to be used with presumably little effect.