The termination provision of many contracts contains the right to terminate upon the other party entering bankruptcy or having a trustee appointed under the U.S. bankruptcy code. Companies are often surprised to find out the right to terminate is unenforceable once the other party has entered bankruptcy. Therefore, it is of utmost importance that companies remain vigilant regarding the creditworthiness of their partners – especially in teaming, subcontract and supply agreements that involve exclusivity provisions.

In accordance with 11 U.S.C. § 365(e)(1), the U.S. bankruptcy code prevents an “executory” contract of a debtor from being terminated or modified at any time after the commencement of a bankruptcy case solely because of a provision in such contract. An “executory” contract is one in which both sides have unperformed obligations which if not performed would be a material breach of the contract. If one party has completed performance and the only remaining obligation is that of the other party to make payment, the contract is no longer an executory contract.

The key to avoiding a scenario where your company is locked into a contract with a bankrupt partner is to obtain as much advance notice as possible of the partner’s deteriorating financial condition. This will allow you to act before bankruptcy, while you still have options. Furthermore, ensure that your contract contains generous termination rights, including the right to terminate prior to bankruptcy based on deteriorating financial condition or inability to pay debts when due.