Court Narrows Safe Harbor Provisions for Commodities and Derivatives Transactions

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1 In re National Gas Distributors, LLC: Court Narrows Safe Harbor Provisions for Commodities and Derivatives Transactions January 2008 Recent amendments to the United States Bankruptcy Code 1 have expanded the scope of parties and transactions entitled to the benefit of its safe harbor provisions for commodities and derivatives transactions. However, in Hutson v. Smithfield Packing Co. (In re National Gas Distributors, LLC), 369 B.R. 884 (Bankr. E.D.N.C. 2007), the United States Bankruptcy Court for the Eastern District of North Carolina concluded that a contract for physical supply of natural gas to an end user was not a swap agreement and that the non-debtor counterparty was therefore not entitled to a safe harbor exemption from avoidance of prepetition transfers. This decision exemplifies the reluctance of some judges to read these safe harbor provisions expansively, even as Congress continues to broaden their scope through successive statutory amendments. The In re National Gas Distributors, LLC decision is controversial. 2 Congress purposely drafted the safe harbor provisions broadly, with a view to preventing the bankruptcy of a commodity or hedge counterparty from causing a disastrous ripple effect throughout the financial markets. The court assumes that where the non-debtor counterparty is an end user, denying it the safe harbor protections will not have an impact in the markets. 3 However, the bankruptcy of Enron, a major player in the energy markets (and incidentally a supplier to numerous end users), did not cause a meltdown of the energy markets precisely because the safe harbor protections worked as they were designed. Denying the safe harbor protections to end users in the Enron bankruptcy could well have precipitated market gridlock and a catastrophic spillover into the financial markets generally. The National Gas Distributors Decision National Gas Distributors, LLC (the Debtor ) filed its voluntary chapter 11 petition on January 20, Accordingly, the case was governed by the 2005 Amendments, but not by the 2006 Amendments to the Bankruptcy Code. Prior to bankruptcy, the Debtor and the defendant Smithfield had entered into a Base Contract for Sale and Purchase of Natural Gas (based on the North American Energy Standards Board, Inc. s Standard Form 6.3.1) (the Base Contract ) and a series of verbal or confirmations under the Base Contract providing for the sale of natural gas by the Debtor to Smithfield for delivery in future months. The Base Contract contained acknowledgements STROOCK & STROOCK & LAVAN LLP NEW YORK LOS ANGELES MIAMI 180 MAIDEN LANE, NEW YORK, NY TEL FAX

2 that each party was a forward contract merchant and that the transactions under the Base Contract constituted forward contracts within the meaning of the Bankruptcy Code. The bankruptcy trustee sued Smithfield, claiming that the Debtor had sold Smithfield natural gas at below market prices in the year prior to bankruptcy, and sought to avoid these transfers under the actual fraudulent transfer provision, 11 U.S.C. 548(a)(1)(A) (as transfers made with actual intent to hinder, delay or defraud creditors) or alternatively under the constructive fraudulent transfer provision, 11 U.S.C. 548(a)(1)(B) (alleging that the Debtor was insolvent at the time of the transfers and received less than reasonably equivalent value in exchange). Smithfield filed an answer and moved for dismissal or summary judgment on the ground that the transfers were made by or to a swap participant in connection with a swap agreement. If correct, this contention would provide an absolute defense to liability for constructive fraudulent transfer. See 11 U.S.C. 546(g). 4 Additionally, it would conclusively establish that Smithfield took the transfers for value for purposes of the actual fraudulent transfer claim, see 11 U.S.C. 548(d)(2)(D), which, coupled with the trustee s concession that Smithfield received the transfers in good faith, would preclude liability for an actual fraudulent transfer. See 11 U.S.C. 548(c). Thus, the sole issue before the court was whether the contract between the parties was a swap agreement with a swap participant. Smithfield s argument was straightforward. Under the 2005 amendments, a swap agreement includes a commodity... forward agreement. 11 U.S.C. 101(53B)(A)(i)(VII). Since the parties contract was a forward contract under 11 U.S.C. 101(25) (i.e., a contract for the purchase or sale of a commodity with a maturity date more than two days after the contract was entered into), and natural gas was a commodity, it also qualified as a commodity forward agreement included in the swap agreement definition. If correct, then Smithfield would qualify as a protected swap participant, which is broadly defined as any entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor. 11 U.S.C. 101(53C). The court disagreed. Its paramount concern was to limit the range of commodity supply contracts to which the swap safe harbor would apply. The court stated in its opinion that an overly broad application of the swap safe harbor could have a drastic impact on many debtors seeking to reorganize in bankruptcy. 5 For example, in addition to exemption from most avoidance claims (the subject of the National Gas Distributors decision), safe harbor status generally permits a counterparty to terminate the contract because of the debtor s bankruptcy, and to exercise rights of setoff and rights to foreclose on collateral pledged by the debtor free of the automatic stay. As the court put it, [i]f this agreement is a swap agreement, then many of the most important aspects of the Code, including priorities of distributions to creditors and the automatic stay, will be eviscerated in even the smallest case of a farmer who contracts to sell his hogs at the end of the month for a set price. Id. National Gas, 369 B.R. at 900. The court suggested this concern is heightened in the context of swaps, where the bar to being a qualifying party is set very low. As noted above, if the contract is a swap agreement, any prepetition counterparty qualifies for protection. See 11 U.S.C. 101(53C). In contrast, though the definition of a forward contract is broad, the protected counterparty bar is set somewhat higher the counterparty must be a forward contract merchant i.e., an entity whose business consists, in whole or in part, of entering into forward contracts as or with a merchant in a commodity. See 11 U.S.C. 101(26). 2

3 The Court s Holding: When is a Forward a Swap? The court rejected Smithfield s analysis as too simplistic. It found the undefined term forward agreement to be ambiguous, and looking to legislative history and the perceived purpose and context of the statute, it concluded that the swap agreement protections were designed to protect the financial markets. Thus forward agreement could only apply to financial instruments that are themselves regularly the subject of trading in a financial market, and not to a contract of the kind at issue here, which is simply an agreement by a single enduser to purchase a commodity. National Gas Distributors, 369 B.R. at Prior to the 2005 Amendments, the swap agreement definition contained a relatively narrow set of swaps, options and swap-like transactions. Id. at 897. The court concluded that though the 2005 Amendments undoubtedly expanded the scope of the definition, this flexibility was added solely to accommodate future developments in the swap markets, without a need to continually revise the Bankruptcy Code, and not to expand protection to agreements that are not the subject of recurrent dealing in the swap markets. In addition to the enumerated types of swap agreements, section 101(53B)(A)(ii) includes similar agreements or transactions that are the subject of recurrent dealing in the swap market. According to the court, the enumerated types of contracts in section 101(53B)(A)(i) are found in financial markets, and they do not include contracts between a seller and an end-user for delivery of a product that happens to be a recognized commodity, where recovery by the trustee would only affect the counterparty and the estate, with no domino effect on a broader financial market. Id. at 899. The court found support for this reading in the legislative history of the 2005 Amendments: Traditional commercial arrangements, such as supply agreements... cannot be treated as swaps under the... Bankruptcy Code because the parties purport to document or label the transactions as swap agreements. Id. at 898 (quoting H.R. Rep. No at ). Thus, viewed in context, the swap agreement safe harbor is meant to protect financial markets and not every sale of a commodity to an end-user. See id. The Court s Dicta: When is a Forward a Forward? Smithfield apparently did not assert the forward contract safe harbor defense. Nevertheless, Smithfield asserted in connection with its commodity forward agreement argument, and the trustee conceded, that the contract was a forward contract. Most of the court s analysis relates to this issue, leading the court to suggest, purely in dicta, that the contract for future shipment of gas was not a forward contract. 6 Under the 2005 Amendments, forward contract was defined in relevant part as: a contract (other than a commodity contract) for the purchase, sale, or transfer of a commodity, as defined in section 761(8) of this title, or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade, or product or byproduct thereof, with a maturity date more than two days after the date the contract is entered into, including, but not limited to, a repurchase transaction, reverse repurchase transaction, consignment, lease, swap, hedge transaction, deposit, loan, option, allocated transaction, unallocated transaction, or any other similar agreement[.] 3

4 11 U.S.C. 101(25)(A). The court focused on two aspects of this definition. First, the court suggested that the phrase which is presently or in the future becomes the subject of dealing in the forward contract trade arguably modified contract instead of similar good, article, service or interest. Thus, the exclusion of commodity contracts could be read to exclude a contract for future supply of a commodity when such contract is not the subject of dealing in the forward contract trade. The court acknowledged, however, that this was likely not the better reading of the provision. Id. at 893, n.3. 7 Second, the court observed that the parenthetical other than a commodity contract may have been intended to exclude simple physical supply contracts to an end user. The court found it significant that Congress had left this use of commodity contract undefined, while elsewhere cross-referencing the definition of commodity contract used in section 761 (i.e., on-exchange commodity futures contracts). The court sought to distinguish In re Olympic Natural Gas Co., 294 F.3d 737 (5th Cir. 2002), which concluded that the commodity contract exclusion was intended to apply to onexchange future delivery contracts, noting that under the Olympic contract each party acted as both buyer and seller, unlike the simple supply contract before the court. Id. at 894; contra Mirant Americas Energy Marketing, L.P. v. Kern Oil & Refining Co. (In re Mirant Corp.), 301 B.R. 548, 566 (Bankr. N.D. Tex. 2004) (definition of forward contract is unambiguous, and agreements at issue constituted a forward contract because [u]nder the Agreements, [the debtor] agreed to sell [counterparty] a commodity, and the Agreements had a maturity more than two days after their execution. ). Notwithstanding this argument, it is clear that under the 2006 Amendments, which added the phrase as defined in section 761 to the commodity contract parenthetical, the parenthetical exclusion is directed at on-exchange commodity future contracts. Thus, the 2006 Amendments undercut the court s analysis with respect to cases governed by the 2006 Amendments. 8 Had the National Gas Distributors case been governed by the 2006 Amendments, another change in the 2006 Amendments would have facilitated an argument that the Smithfield contract was a safe-harbored forward contract. Whereas the 2005 version of the Bankruptcy Code only protected margin payments and settlement payments from avoidance, the 2006 Amendments also protect a transfer made by or to (or for the benefit of)... a forward contract merchant... in connection with a... forward contract, which readily encompasses a delivery of gas under the contract. 9 This is not to say the issue has been definitely resolved. First, the 2006 Amendments, while removing the textual basis for the Court s analysis, do not expressly address the Court s view that the forward contract provisions only protect contracts that are the subject of dealing in the forward contract trade, in contrast to one-way supply agreements for physical delivery to an end-user. Secondly, a Texas bankruptcy court has concluded that in order to be a forward contract merchant, a counterparty must have entered into the forward contract as a participant seeking profit in the forward contract trade. See In re Mirant, 310 B.R. at 570. A court following these decisions could conclude that an end-user purchaser of a commodity is not eligible for forward contract safe harbor protection. On the other hand, the definition of forward contract merchant encompasses a party who enters into a forward contract as or with a merchant in the commodity (indicating that only one party to the contract needs to be a merchant in the commodity). In many cases involving an end user supply contract, the supplier itself enters into both physically and financially settled transactions, and hedges its entire business. If such a supplier is not within the safe harbor protections, avoidance by the 4

5 bankruptcy trustee could produce the very domino effect in the financial market that Congress sought to avoid. By Mark A. Speiser ( ), a Partner in the Financial Restructuring Practice Group of Stroock & Stroock & Lavan LLP, Harold A. Olsen ( ), a Special Counsel in Stroock s Financial Restructuring Practice Group, and Marvin J. Goldstein ( ), a Partner in Stroock s Derivatives & Commodities and Corporate Practice Groups U.S.C. 101 et seq. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, effective in bankruptcy cases filed on or after October 17, 2005, and the Financial Netting Improvements Act of 2006, effective in cases filed on or after December 12, 2006, each contain amendments to the derivative safe harbor provisions of the Bankruptcy Code (the 2005 Amendments and the 2006 Amendments respectively). For further information about these amendments, see Financial Netting Improvements Act of 2006, Stroock Special Bulletin, February 1, 2007 at and Derivatives Provisions of the 2005 Bankruptcy Amendments, Stroock Special Bulletin, April 22, 2005 at 2. As of this writing, an appeal of the decision is pending before the United States Court of Appeals for the Fourth Circuit, pursuant to 28 U.S.C. 158(d)(2) (permitting certification of a bankruptcy appeal directly to the Circuit Court of Appeals in certain instances). 3. This conclusion has been challenged by The International Swaps and Derivatives Association, Inc. ( ISDA ), which points out in an amicus curiae brief to the Fourth Circuit Court of Appeals that the Bankruptcy Court s narrowing of the scope of the Bankruptcy Code s safe harbors with respect to derivative transactions will have a disruptive and deleterious effect on the financial markets. See Hutson v. E.I. DuPont de Nemours & Co., Inc., et al., Statement of Amicus Curiae The International Swaps and Derivatives Association, Inc. in Support of Joint Petition of E.I. DuPont de Nemours and Company and The Smithfield Packing Company, Incorporated for Permission to appeal Directly from Order of the Bankruptcy Court Pursuant to 28 U.S.C. 158(d)(2) and Federal Rule of Appellate Procedure 5, at 4 (4th Cir., filed December 6, 2007). As ISDA notes, many financial market participants are now engaging in both physically- and financially-settled energy commodity transactions, and [a]ny bankruptcy engendered maloccurrence in either sub-market can pass rapidly to the other through the books of entities active in both. Id. at Notably, Smithfield did not argue it was protected under 11 U.S.C. 546(e), which under the 2005 Amendments protected margin or settlement payments made by or to a forward contract merchant. Smithfield argued that the parties contract was a forward contract, but only to advance its argument, discussed below, that it also constituted a forward agreement under the swap agreement definition. 5. See National Gas, 369 B.R. at The potential for adverse impact on the estate is not unique to the safe harbor provisions. For example, while the availability of postpetition financing is typically critical to a debtor s reorganization, the Code does not permit a debtor to assume and enforce an executory contract to make a loan. See 11 U.S.C. 365(c)(2). Instead, the Code separately provides mechanisms to encourage voluntary postpetition financing. See 11 U.S.C No similar statutory mechanism exists specifically for safe harbored contracts, yet in both the Mirant and Calpine bankruptcies, where mass termination of safe harbored commodity contracts would have devastated the debtors businesses, the debtors were able to preserve existing trades and promote new trading activities through counterparty assurance programs whereby safe harbor counterparties were incentivized to forebear from terminating their contracts in exchange for a package of protections, including assumption of those contracts. 6. The court acknowledged that whether the contract was a forward contract was not dispositive, and assumed with the trustee that it was, while suggesting the contrary may be the correct result. 7. Among other infirmities of this construction, if the subject of dealing language modified contract, then the adjacent language product or byproduct thereof would nonsensically apply to the contract, rather than to the commodity. 8. The court acknowledged this subsequent statutory amendment, but merely observed that the 2006 Amendments were not applicable to the case before it. National Gas, 369 B.R. at 895, n The 2006 Amendments do not, however, bolster Smithfield s swap argument forward agreement remains undefined. 5

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