Of Hogs, Electricity and Gas

11 U.S.C. ' 546

Under BAPCPA, Congress significantly expanded the protections of ' 546 for financial derivative participants. See National Gas, 556 F.3d at, 255. For example, a forward transaction could be a swap agreement even if it is not a forward contract. Id. One commentator noted that “[t]he expanded definitions ' especially the definition of 'swap agreement' ' are now so broad that nearly every derivative contract is subject to the Code's protection.” Edward R. Morrison and Joerg Riegel, Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges, 13 Am. Bankr. Inst. L. Rev. 641, 652 (2005).

In addition to providing protection to a broad array of financial instruments, these expanded definitions have created confusion. While the definition of a swap agreement is broad, traditional commercial arrangements do not fall within the exception provided by ' 546 and, as such, merely labeling a contract a swap agreement is not sufficient to gain protection under that statute. Courts are required to determine whether a subject agreement is a derivative contract or a simple supply agreement. See In re National Gas Distributors, 556 F.3d at 258. Bankruptcy courts' reluctance to upset the priority scheme of bankruptcy by elevating form over substance may result in case law that ignores the complexities and the realities of the financial markets.

The National Gas Decisions

In National Gas I, the Trustee sought to avoid transfers made under natural gas supply contracts as fraudulent pursuant to ' 548 (avoidance of fraudulent transfer). Three customers filed a motion to dismiss on the ground that the contracts were forward swap agreements protected by the safe harbor of ' 546(g). The bankruptcy court noted that the statute's purpose was to protect the financial markets. While not deciding the boundaries of what a swap agreement includes, the bankruptcy court found that the subject agreements were “simply [agreements] by an end-user to purchase a commodity” and, as such, were not excluded as swap agreements. Id. at 899. The court reasoned “[i]f this agreement is a swap agreement, ' then a farmer who contracts to sell his hogs at the end of the month for a set price [would also be protected by the safe harbor].” Id. at 900.

In stark contrast to the broad application of the statute set out in its legislative history, the court applied a decidedly narrow interpretation, noting that if the “contract is not clearly within the definition of swap agreement, the court will not upset the priority scheme of the Bankruptcy Code by affording the transfers under the contract the protections afforded to swap agreements.” National Gas I, 369 B.R. at 900. Thus, the bankruptcy court denied the motion to dismiss.

On a direct interlocutory appeal from the bankruptcy court's order, the Fourth Circuit reversed the bankruptcy court's holding. The Fourth Circuit found that the bankruptcy court erred in holding that as a matter of law the subject contract was not included in the safe harbor because it was not traded on an exchange or in a financial market and involved physical delivery of the commodity to an end user. It explained that the statute's language and a substantial body of case law stands for the proposition that “swap agreements” can include agreements contemplating physical delivery. National Gas, 55 F.3d at, 258. Second, the Fourth Circuit noted “[a]lthough the contracts in this case did provide a supply of gas to the customers' facilities, they also were part of a series of contracts by which the customers hedged their risk of future fluctuations in the price of natural gas.” Id. at 257. The Fourth Circuit observed that these contracts, although non-assignable and for the physical delivery, could influence the financial markets. For example, the Seventh Circuit explained that farmers' forward contracts with grain merchants affected commodities markets contracts because the grain merchants trade in established futures markets. Nagel v. ADM Investor Servs., Inc., 217 F.3d 436, 438-39 (7th Cir. 2000). (Based on the reasoning of the Fourth and Seventh Circuits, the hog farmer addressed by the bankruptcy court is likely to be protected by the safe harbor.)

The Fourth Circuit remanded the case and provided four nonexclusive elements that the statutory language appears to require. “First, the subject of a commodity forward agreement must be a commodity.” National Gas 556 F.3d, at 259. “Second, a forward commodity contract, in being 'forward,' must require a payment for the commodity at a price fixed at the time of contracting for delivery more than two days after the date the contract is entered into.” Id. at 260. “Third, as a forward agreement in relation to a commodity, in addition to the price element, the quantity and time elements must be fixed at the time of contracting.” Id. “Finally, ['] swap agreements' also include forward contracts, which are not necessarily assignable.” Id.

Did the National Gas Distributors Court Get It Right the Second Time?

The National Gas bankruptcy court had the opportunity to revisit forward supply contracts for natural gas with different defendants. While in its prior opinion the court addressed the effect of the subject contracts on the financial markets, this time the court barely addressed the issue. The court did not analyze whether the instruments were intended to be protected by BAPCPA's broad language or how the subject contract functioned in the market. Rather, the bankruptcy court focused on the Fourth Circuit's third non-exclusive element that the amount be fixed at the time of contracting. The defendants argued that the unique aspects of natural gas do not require a swap agreement to have a fixed amount. National Gas II, 412 B.R. at 766. Not surprisingly, the bankruptcy court found that the subject contracts lacked a fixed amount and, as a matter of law, the contracts were not forward swap agreements. Id.

In re MBS Management Services

In In re MBS, the court was faced with a question whether a supply contract for electricity can qualify as a forward contract for the purposes of 11 U.S.C. ' 546(e). The trustee/plaintiff sought to avoid transfers made pursuant to a supply contract for electricity, arguing that such a contract “lacks the hallmarks of a hedging or forward transaction and provides an imperfect hedge.” MBS I, 430 B.R. at 756. The trustee later refined his argument that “hedging was not the primary goal, and as such it was not a forward contract.” MBS II, 432 B.R. at, 577 . Furthermore, the trustee invoked National Gas II's guidance regarding the absence of a specified amount in the supply contract. The court noted that the statute contains few requirements for a contract to qualify as a forward contract: “(a) sale of a commodity; (b)with a maturity date more than two days after execution; (c) by a forward contract merchant; [and] (d) not otherwise subject to the rules or market of a contract board of trade.” MBS I, 430 B.R. at, 754. The court found in addition to these statutory requirements, “industry standards, risks, and market practices should govern the criteria necessary to define any particular contract as fitting within the statute's definition.” Id. at 757. The court explained that a crucial element in its analysis is whether “the primary risk to those purchasing electricity is price volatility” and “the contract acts as a hedge against the primary risk to both buyer and seller.” Id. Thus, the court found based on the evidence and expert testimony that the subject electric supply contract served to hedge against fluctuating prices and, as such, was protected by the safe harbor under 546.

Importantly, MBS analyzed the National Gas II's holding that a forward contract requires a fixed amount. National Gas noted that “The Wall Street Journal always quotes commodity contracts by price and quantity, observing that both must be specified in order for a forward contract to exist.” Id. at 576. MBS distinguished those contracts, explaining that they were future contracts and regulated and traded on exchanges and, as such, require uniformity. In contrast, forward contracts are off-exchange trades, and, as a result, they often vary in their terms. Thus, limiting the safe harbor to forward contracts containing “a condition that is not typically present would defeat the purpose of ' 546(e) by narrowing its application.” Id.

Looking Forward

The disparate approaches of these decisions highlights the uncertainty that counterparties are faced with when entering into forward supply agreements. This uncertainty may be limited by bifurcating the contract into separate sections, one addressing the minimum requirements (which will be protected by the safe harbor) and a second section addressing the unknown (both the amount required and the treatment in bankruptcy). Likewise, to meet the hyper technical requirement of National Gas, a forward supply agreement could be recast as a fixed contract for the maximum possible amount with a rebate for the unused portion.

Conclusion

These recent rulings by bankruptcy courts in North Carolina and Louisiana provide important guidance beyond those districts regarding forward supply contracts. As other courts have not addressed these contracts directly, these decisions serve as a road map for how a court may analyze any forward supply contracts. Additionally, a court's general approach to the safe harbor of ' 546 provides valuable guidance. A court that has broadly interpreted the statute or values economic theory is more likely to follow the MBS approach. In contrast, courts that have narrowly construed the statute will likely follow the bankruptcy court's decision in National Gas.

Yitzhak Greenberg practices law in New York. He has prosecuted and defended numerous preference and fraudulent conveyance actions, including those involving derivative contracts. Greenberg can be reached at [email protected].

A split among bankruptcy courts has called into question whether supply contracts for commodities such as hogs, electricity and gas will receive the same protection that has been extended to swaps and other financial contracts under ' 546 of the Bankruptcy Code. That section provides a safe harbor to transfers made pursuant to financial contracts. The stability of these contracts is deemed so essential to the health of the nation's financial markets that they are broadly excepted from avoidance as preferences and fraudulent transfers. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) further clarified the broad intent and application of the safe harbor of ' 546.

Businesses' ability to rely on ' 546 to insulate their supply agreements (i.e., contracts that do not specify an amount of the commodity) from the potentially disruptive effects of a bankruptcy filing by their counterparties has been called into question. Recently, two bankruptcy courts had the opportunity to apply BAPCPA to forward supply contracts and agreements and came to very different conclusions. In one line of decisions, the Louisiana Bankruptcy Court looked to the purpose of the specific agreements and industry usage and found that the supply forward contracts qualified as a “forward contract” protected by ' 546(e) (addressing forward contracts). See In re MBS Management Services, Inc., 430 B.R. 750, 757 (Bankr. E. D. La. 2010) (hereinafter, “MBS I“); see also In re MBS Management Services, Inc., 432 B.R. 570, 577 (Bankr. E.D. La. 2010) (hereinafter, “MBS II“) (finding that the subject contracts were protected by the safe harbor of ' 546(e)).

A North Carolina bankruptcy court, in contrast, took a very narrow view of the safe harbor finding that the forward supply agreements were not protected by ' 546(g) (addressing swap agreements). In re National Gas Distributors, LLC, 369 B.R. 884, 900 (Bankr. E.D.N.C. 2007) (hereinafter, “National Gas I“) rev'd sub nom. In re National Gas Distributors. LLC, 556 F.3d 247 (4th Cir. 2009) (finding the bankruptcy court construed “forward agreement” too narrowly). Despite the Fourth Circuit's reversal, when the bankruptcy court faced the exact same question, it again found the forward supply agreements were not protected by the safe harbor of ' 546(g), albeit for a different reason. In re National Gas Distributors, LLC, 412 B.R. 758 (Bankr. E.D.N.C. 2009) (hereinafter, “National Gas II“). This article analyzes the two courts' opinions and provides practical analysis of the effects of the decisions on other courts and the industry.

11 U.S.C. ' 546

Under BAPCPA, Congress significantly expanded the protections of ' 546 for financial derivative participants. See National Gas, 556 F.3d at, 255. For example, a forward transaction could be a swap agreement even if it is not a forward contract. Id. One commentator noted that “[t]he expanded definitions ' especially the definition of 'swap agreement' ' are now so broad that nearly every derivative contract is subject to the Code's protection.” Edward R. Morrison and Joerg Riegel, Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges, 13 Am. Bankr. Inst. L. Rev. 641, 652 (2005).

In addition to providing protection to a broad array of financial instruments, these expanded definitions have created confusion. While the definition of a swap agreement is broad, traditional commercial arrangements do not fall within the exception provided by ' 546 and, as such, merely labeling a contract a swap agreement is not sufficient to gain protection under that statute. Courts are required to determine whether a subject agreement is a derivative contract or a simple supply agreement. See In re National Gas Distributors, 556 F.3d at 258. Bankruptcy courts' reluctance to upset the priority scheme of bankruptcy by elevating form over substance may result in case law that ignores the complexities and the realities of the financial markets.

The National Gas Decisions

In National Gas I, the Trustee sought to avoid transfers made under natural gas supply contracts as fraudulent pursuant to ' 548 (avoidance of fraudulent transfer). Three customers filed a motion to dismiss on the ground that the contracts were forward swap agreements protected by the safe harbor of ' 546(g). The bankruptcy court noted that the statute's purpose was to protect the financial markets. While not deciding the boundaries of what a swap agreement includes, the bankruptcy court found that the subject agreements were “simply [agreements] by an end-user to purchase a commodity” and, as such, were not excluded as swap agreements. Id. at 899. The court reasoned “[i]f this agreement is a swap agreement, ' then a farmer who contracts to sell his hogs at the end of the month for a set price [would also be protected by the safe harbor].” Id. at 900.

In stark contrast to the broad application of the statute set out in its legislative history, the court applied a decidedly narrow interpretation, noting that if the “contract is not clearly within the definition of swap agreement, the court will not upset the priority scheme of the Bankruptcy Code by affording the transfers under the contract the protections afforded to swap agreements.” National Gas I, 369 B.R. at 900. Thus, the bankruptcy court denied the motion to dismiss.

On a direct interlocutory appeal from the bankruptcy court's order, the Fourth Circuit reversed the bankruptcy court's holding. The Fourth Circuit found that the bankruptcy court erred in holding that as a matter of law the subject contract was not included in the safe harbor because it was not traded on an exchange or in a financial market and involved physical delivery of the commodity to an end user. It explained that the statute's language and a substantial body of case law stands for the proposition that “swap agreements” can include agreements contemplating physical delivery. National Gas, 55 F.3d at, 258. Second, the Fourth Circuit noted “[a]lthough the contracts in this case did provide a supply of gas to the customers' facilities, they also were part of a series of contracts by which the customers hedged their risk of future fluctuations in the price of natural gas.” Id. at 257. The Fourth Circuit observed that these contracts, although non-assignable and for the physical delivery, could influence the financial markets. For example, the Seventh Circuit explained that farmers' forward contracts with grain merchants affected commodities markets contracts because the grain merchants trade in established futures markets. Nagel v. ADM Investor Servs., Inc. , 217 F.3d 436, 438-39 (7th Cir. 2000). (Based on the reasoning of the Fourth and Seventh Circuits, the hog farmer addressed by the bankruptcy court is likely to be protected by the safe harbor.)

The Fourth Circuit remanded the case and provided four nonexclusive elements that the statutory language appears to require. “First, the subject of a commodity forward agreement must be a commodity.” National Gas 556 F.3d, at 259. “Second, a forward commodity contract, in being 'forward,' must require a payment for the commodity at a price fixed at the time of contracting for delivery more than two days after the date the contract is entered into.” Id. at 260. “Third, as a forward agreement in relation to a commodity, in addition to the price element, the quantity and time elements must be fixed at the time of contracting.” Id. “Finally, ['] swap agreements' also include forward contracts, which are not necessarily assignable.” Id.

Did the National Gas Distributors Court Get It Right the Second Time?

The National Gas bankruptcy court had the opportunity to revisit forward supply contracts for natural gas with different defendants. While in its prior opinion the court addressed the effect of the subject contracts on the financial markets, this time the court barely addressed the issue. The court did not analyze whether the instruments were intended to be protected by BAPCPA's broad language or how the subject contract functioned in the market. Rather, the bankruptcy court focused on the Fourth Circuit's third non-exclusive element that the amount be fixed at the time of contracting. The defendants argued that the unique aspects of natural gas do not require a swap agreement to have a fixed amount. National Gas II, 412 B.R. at 766. Not surprisingly, the bankruptcy court found that the subject contracts lacked a fixed amount and, as a matter of law, the contracts were not forward swap agreements. Id.

In re MBS Management Services

In In re MBS, the court was faced with a question whether a supply contract for electricity can qualify as a forward contract for the purposes of 11 U.S.C. ' 546(e). The trustee/plaintiff sought to avoid transfers made pursuant to a supply contract for electricity, arguing that such a contract “lacks the hallmarks of a hedging or forward transaction and provides an imperfect hedge.” MBS I, 430 B.R. at 756. The trustee later refined his argument that “hedging was not the primary goal, and as such it was not a forward contract.” MBS II, 432 B.R. at, 577 . Furthermore, the trustee invoked National Gas II's guidance regarding the absence of a specified amount in the supply contract. The court noted that the statute contains few requirements for a contract to qualify as a forward contract: “(a) sale of a commodity; (b)with a maturity date more than two days after execution; (c) by a forward contract merchant; [and] (d) not otherwise subject to the rules or market of a contract board of trade.” MBS I, 430 B.R. at, 754. The court found in addition to these statutory requirements, “industry standards, risks, and market practices should govern the criteria necessary to define any particular contract as fitting within the statute's definition.” Id. at 757. The court explained that a crucial element in its analysis is whether “the primary risk to those purchasing electricity is price volatility” and “the contract acts as a hedge against the primary risk to both buyer and seller.” Id. Thus, the court found based on the evidence and expert testimony that the subject electric supply contract served to hedge against fluctuating prices and, as such, was protected by the safe harbor under 546.

Importantly, MBS analyzed the National Gas II's holding that a forward contract requires a fixed amount. National Gas noted that “The Wall Street Journal always quotes commodity contracts by price and quantity, observing that both must be specified in order for a forward contract to exist.” Id. at 576. MBS distinguished those contracts, explaining that they were future contracts and regulated and traded on exchanges and, as such, require uniformity. In contrast, forward contracts are off-exchange trades, and, as a result, they often vary in their terms. Thus, limiting the safe harbor to forward contracts containing “a condition that is not typically present would defeat the purpose of ' 546(e) by narrowing its application.” Id.

Looking Forward

The disparate approaches of these decisions highlights the uncertainty that counterparties are faced with when entering into forward supply agreements. This uncertainty may be limited by bifurcating the contract into separate sections, one addressing the minimum requirements (which will be protected by the safe harbor) and a second section addressing the unknown (both the amount required and the treatment in bankruptcy). Likewise, to meet the hyper technical requirement of National Gas, a forward supply agreement could be recast as a fixed contract for the maximum possible amount with a rebate for the unused portion.

Conclusion

These recent rulings by bankruptcy courts in North Carolina and Louisiana provide important guidance beyond those districts regarding forward supply contracts. As other courts have not addressed these contracts directly, these decisions serve as a road map for how a court may analyze any forward supply contracts. Additionally, a court's general approach to the safe harbor of ' 546 provides valuable guidance. A court that has broadly interpreted the statute or values economic theory is more likely to follow the MBS approach. In contrast, courts that have narrowly construed the statute will likely follow the bankruptcy court's decision in National Gas.

Yitzhak Greenberg practices law in New York. He has prosecuted and defended numerous preference and fraudulent conveyance actions, including those involving derivative contracts. Greenberg can be reached at [email protected].