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New Light Shed by Fourth Circuit on Bankruptcy 'Safe Harbors' for Commodity Forward Contracts

4/06/2009

Decision Important for Energy Industry and for Avoidance Litigation

The Fourth Circuit Court of Appeals recently has confirmed that the Bankruptcy Code definition of a commodity “forward contract” includes a supply contract that contemplates the physical delivery of a commodity, in this case, natural gas, without a requirement that the contract be traded on a financial market or settled through a financial exchange. The decision is important to the energy industry. It also is important to bankruptcy preference litigation, in general, because payments made pursuant to “commodity forward contracts” are exempt from preference recapture pursuant to Bankruptcy Code §546(e), even if made within 90 days prior to bankruptcy. When coupled with the broad statutory definitions of “commodity” and “forward contract,” the Fourth Circuit decision could help pave the way for payments made pursuant to many kinds of supply contracts to be treated as exempt from preference recapture.

In the energy industry, transactions involving the sale of millions of dollars of product are routine. When a customer files for bankruptcy, it can have an enormous impact on the financial health of the non-debtor. To mitigate some of the harm, Congress enacted special safe harbor provisions that exempt the exercise of certain rights under specified agreements such as forward contracts, swaps, repurchase agreements and other types of risk mitigating vehicles from various provisions of the Code including, inter alia, the automatic stay, preference and fraudulent conveyance provisions. One lingering concern industry participants have held is whether contracts that involve the physical delivery of product and are not traded on an exchange nevertheless fall within the safe harbor scheme. In a recent decision, In re National Gas Distributors LLC, 556 F.3d 247 (4th Cir. 2009), the Fourth Circuit Court of Appeals has attempted to answer that question.

The National Gas Distributors LLC Decision

During the year before its Chapter 11 filing, National Gas Distributors LLC had entered into several contracts for the supply and physical delivery of natural gas. The contracts were on standard forms generated by the North American Energy Standards Board and declared themselves to be a “forward contract.” Negotiated terms included future delivery of natural gas during specified time periods, with performance to commence two days after any contract was executed. The contracts required the parties to sell and deliver gas at a fixed price. If a party breached its obligation, it had to pay the difference between the contract price and the market price.

The trustee for National Gas’s Chapter 11 estate apparently believed that the contracts obligated the debtor to sell product below market. Therefore, he commenced adversary proceedings against former customers to avoid the supply contracts and transfers of natural gas made pursuant thereto as fraudulent conveyances and recover the difference in value between the contract price at which the gas had been sold and the prevailing market price. The customers argued that the contracts were “commodity forward agreements,” included in the definition of “swap agreements” under the Code and, therefore, the contracts and transfers were exempt from the trustee’s avoidance powers. Successfully characterizing the underlying contracts as a “swap agreement” would defeat the trustee’s claims pursuant to section 546(g), which shields transfers made in connection with a swap, whereas section 546(e)—a similar safe harbor provision applicable to “forward contracts”—protects only transfers that are margin or settlement payments.

Disagreeing with the customers, the bankruptcy court held that the contracts were not commodity forward agreements. The bankruptcy court reasoned that the contracts were insufficiently tied to the financial market as they were not traded on any financial market nor settled by a financial exchange and thus were nothing more than simple supply contracts. Left as is, the bankruptcy court’s decision would potentially preclude industrial energy consumers and sellers from liquidating a transaction with a bankrupt counterparty, or from realizing against any property posted as collateral, without first obtaining relief from the automatic stay.

On direct, interlocutory appeal, the Fourth Circuit reversed and remanded the case back to the bankruptcy court for further consideration.

The Fourth Circuit noted that Congress had created safe harbor provisions for participants in the financial derivative markets. Without safe harbor provisions, if a party who had entered into a variety of these types of contracts files for bankruptcy, counterparties would find themselves exposed to the automatic stay for extended periods, unable to liquidate their contracts and thereby limit their exposure to market movements. Furthermore, a debtor could “cherry-pick” beneficial contracts, effectively locking in profitable contracts and disposing of unprofitable ones. This potential artificial market behavior could ripple through the commodities market, having the domino effect of potentially spreading a debtor’s insolvency to other market participants and quite possibly threatening the collapse of the entire market.

Keeping the congressional intent in mind, the Fourth Circuit disagreed with the bankruptcy court’s determination that the natural gas contracts were simple supply contracts and not “swap agreements” within the meaning of the safe harbor provisions under the Code. The fact that a contract contemplates the physical delivery of a commodity does not preclude it from being a swap agreement. Even though the contracts provided for the physical supply of gas to customers, they were part of a series of transactions in which the customers hedged their risk of future price fluctuations. Indeed, the court found that the contracts themselves represented a form of hedging by virtue of the present fixing of a price for future delivery of a product. The court also found that while this type of contract is not traded, it potentially could have a direct influence on the financial markets in which natural gas hedges were traded. The court concluded that the natural gas contracts might well fit within the type of contracts that Congress intended to specially treat under the Code.

Although the National Gas customers identified the contracts at issue as a “commodity forward agreement,” the Code itself does not contain an express definition of such agreements. The Fourth Circuit reasoned that a “contract” is a type of “agreement.” However, every “agreement” is not necessarily a “contract.” Therefore, a “forward contract” is a subset of “forward agreements.” The Code does define the term “forward contract;” under the Code, a forward contract does not need to be traded on an exchange or in the market, can be negotiated directly with parties and can provide for physical delivery of the commodity. See also In the Matter of Olympic Natural Gas Co., 294 F.3d 737, 741 (5th Cir. 2002) (which held that “forward contracts” do not need to be traded on an exchange or in a market, may be directly negotiated between the parties and may provide for physical delivery of the commodity). Therefore, a “forward agreement,” being even broader than “forward contract,” should not have restrictions requiring trade on an exchange.

While the Fourth Circuit stopped short of providing a fixed definition of a “commodity forward agreement,” it did identify four characteristics: (1) the subject of a commodity forward agreement must be a commodity (distinguishing a commodity agreement from other supply contracts that attribute a large portion of costs to packaging, marketing, transportation, or other similar costs), (2) in being “forward,” it must require a payment for a commodity at a fixed price to be delivered more than two days after the date of the agreement, (3) the quantity to be delivered and the timing elements in the agreement must be fixed at the time the agreement is entered into by the parties, and (4) there is no requirement that the contract be traded on an exchange or in the financial markets.

The Fourth Circuit’s decision provided welcome news to the energy markets by creating more clarity regarding whether particular contracts will fall within the safe harbor provisions. Specifically, physical delivery of product does not appear to be a disqualifying component nor does the contract need to be traded on an exchange. However, the fixed-price component raises a potential red flag. If by “fixed price” the circuit court meant that it could include an index price, then that would comport with how many contracts are structured today. However, if the price must truly be fixed, then many contracts now used may not fall within the definition of a forward agreement or forward contract.

J. Gregg Miller, Francis J. Lawall and Nina M. Varughese