Introduction

This alert has been prompted by a recent decision of the U.S. Court of Appeals that has a potentially huge impact on the treatment under U.S. bankruptcy law of contracts that entail a physical delivery of commodities. The decision is a positive development for those that had entered into a physically settled transaction with an entity which has subsequently become subject to a U.S. bankruptcy procedure as such transactions may qualify as a "swap agreement" and therefore fall within the "safe harbor" provisions of the U.S. Bankruptcy Code which, in essence, allow for contractual close-out netting and certain other key safeguards.

On February 11, 2009, in Hutson v E.I. Dupont De Nemours & Co. et al (In re National Gas Distributors LLC), a case of first impression, the U.S. Court of Appeals for the Fourth Circuit (the "Court of Appeals") determined that a physically settled "commodity forward agreement" may qualify as a "swap agreement" under the U.S. Bankruptcy Code ("Bankruptcy Code"), and fall within the so-called safe harbor provisions of the Bankruptcy Code, regardless of whether these over-the-counter ("OTC") transactions are (a) settled by physical delivery of a commodity (rather than cash) (b) assignable, or (c) traded on a financial market or exchange. In the underlying bankruptcy case, the Trustee was seeking to set aside certain gas forward contracts not because they were fraudulent per se, but because the debtor had sold counterparties gas for less than the market value at the time of the transaction and at a time when the debtor was presumably insolvent (so-called "constructive fraudulent conveyances" under U.S. bankruptcy law).

Significantly for the parties to the underlying disputes over contracts for the sale and purchase of natural gas, the safe harbor provisions include, among other special rights, exemption of settlements and related transfers from a trustee's avoidance powers (the power in certain circumstances to avoid pre-petition transactions and recover said value for the debtor's estate).

The Bankruptcy Code Safe Harbors

The safe harbors comprise a set of statutory provisions under the Bankruptcy Code which apply to certain financial contracts and the counterparties thereto, excepting those contracts from certain restrictions of the automatic stay and allowing non-debtor counterparties to "swap agreements", forward agreements and other financial contracts special rights. Such rights include, among other things, the right upon a bankruptcy filing to terminate, liquidate and accelerate a "swap agreement", apply master netting agreements and contractual set-off rights, and to foreclose on pledged collateral. In addition, the safe harbors protect, or exempt, non-debtor counterparties from the debtor's or its trustee's avoidance powers – namely the right to bring preferences and fraudulent conveyance claims against creditors and other third parties, regardless of any intentional wrongdoing on their parts, and to do so in the name of the debtor's estate as a means of recapturing value transferred by the debtor to third parties prior to the bankruptcy case filing.

While the safe harbor provisions generally apply to "swap agreements" as broadly defined by the Bankruptcy Code, there has been considerable dispute among bankruptcy courts in the U.S. about whether physically settled commodity forward contracts in fact constitute "swap agreements" and thus fall within the safe harbors, or whether they are simply to be treated as physical supply contracts between sellers and end-users devoid of such protections. As discussed below, the Court of Appeal's decision provides significant clarification and some direction to parties to such forward contracts.

The Contracts and the Bankruptcy Court Decision

In December 2006, during the In re Natural Gas LLC bankruptcy case pending before the U.S. Bankruptcy Court for the Eastern District of North Carolina ("Bankruptcy Court"), Richard M. Hutson, the court-appointed Trustee for the debtor, filed actions to avoid, or reverse, the debtor gas distributor's contracts with numerous customers and recover from the customers over $4 million USD on the grounds that the contracts (and any related transfers of gas for cash) were entered into at below market prices at a time when the debtor was insolvent and, as such, were constructively fraudulent conveyances and transfers of value prior to the commencement of the bankruptcy case.

The contracts at issue in the case were entered into by the debtor and the customers prior to commencement of the debtor's bankruptcy proceeding, and enabled the customers to hedge against adverse changes in the price of natural gas by requiring the debtor to sell and deliver gas and the customers to receive and purchase gas at a fixed price over the respective terms of the contracts. The customers filed motions to dismiss the Trustee's complaint or for summary judgment on the basis that the contracts were "commodity forward agreements," a type of "swap agreement" exempt from the avoidance powers otherwise afforded to the debtor under the Bankruptcy Code, and cited among their support the express statutory definitions of the subject agreements and legislative history of the Bankruptcy Code. Further, the customers asserted that the contracts were in fact hedging contracts that were part of a larger risk management program through which they regularly used forwards and other derivatives.

The Bankruptcy Court issued orders on May 24, 2006 (the "Initial Orders") that denied the customers' motions and concluded that the contracts were not "commodity forward agreements," and were, as a matter of law, "agreements by a single end-user to purchase a commodity," rather than "swap agreement" exempt from the avoidance powers otherwise afforded to the debtor under the Bankruptcy Code. Analyzing the legislative history and statutory construction of the Bankruptcy Code's definition of "swap agreements", the Bankruptcy Court determined that any such agreement must be "regularly the subject of trading in financial markets" and must be settled by financial exchanges of differences in commodity prices. The contracts, by comparison, were directly negotiated between the debtor and the respective customers and contemplated physical delivery of the commodity (gas) to the purchasers. The customers filed motions to amend the Initial Orders to allow for the development of certain factual findings in support of the position that the contracts indeed qualified as commodity forward agreements and, by extension, "swap agreements", and were joined with an amicus brief by the International Swaps and Derivatives Association. However, on June 20, 2007, the Bankruptcy Court denied the motions to amend, reiterating that, as a matter of law, the contracts were not commodity forward agreements or "swap agreements" – rather, the contracts were "simple supply contracts" for the future delivery of a commodity, and thus no factual findings were mandated.

The customers sought and obtained leave to appeal directly to the Court of Appeals (which leave is infrequently granted), citing the legal issues of interpreting physically settled commodity forward contracts under the Bankruptcy Code as a case of first impression in the jurisdiction.

The Court of Appeals' holding

Upon appeal, the Court of Appeals reversed the Bankruptcy Court on virtually all grounds, finding that "commodity forward contracts" are both "commodity forward agreements" and "swap agreements" under the Bankruptcy Code, and further holding that the Bankruptcy Court orders rested upon two patently false assumptions.

First, the Court of Appeals rejected the Bankruptcy Court's assumption that a "swap agreement," which is defined to include a "commodity forward agreement," must be "regularly the subject of trading in financial markets." The Court of Appeals based its rejection on the twin principles that:

• every "forward contract" is a "forward agreement", since the term "agreement" is broader than and encompasses the term "contract," and
• the legislative history, case law, and market practices relating to forward contracts permit such contracts to be directly negotiated and do not require that such contracts to be traded in a financial market.

Significantly, the Court of Appeals pointed out that the contracts, although privately negotiated and quite possibly not assignable, were part of an overall hedging program for each of the customers that involved other transactions that were traded in financial markets.

Second, on the basis of legislative history, case law, and common definitions of a forward agreement, the Court of Appeals rejected the Bankruptcy Court's assumption that a "commodity forward agreement" must be cash-settled. Citing to decisions of federal courts ranging from Texas to Delaware, as well as the 2005 and 2006 Congressional amendments to the Bankruptcy Code, the Court of Appeals noted that just as forward contracts may be physically settled, so too may be forward agreements.

While the Court of Appeals did not instruct the Bankruptcy Court to find that the individual subject contracts were "commodity forward agreements" or "swap agreements," it did remand the case for further proceedings consistent with the appellate decision.

Conclusion

Accordingly, we now await the outcome on remand to the Bankruptcy Court of the customers' attempts to demonstrate factually and legally that their contracts did qualify as "swap agreements" and/or "commodity forward agreements". If successful in this demonstration, then the customers' pre-bankruptcy settlements (including pre-bankruptcy deliveries of gas) under the contracts at issue in this case will be exempt from the Trustee's avoidance powers.

Nevertheless, the Court of Appeals decision brings commodity forward contracts squarely within the scope and protections of the Bankruptcy Code safe harbor provisions, regardless of whether they are physically or cash settled. The decision is binding on courts within the 4th Circuit and likely to materially influence other courts considering similar issues. Practitioners and participants in the OTC derivatives markets are well advised to review carefully the Court of Appeals reasoning as it provides a roadmap for key acknowledgments to be exchanged by counterparties to contracts for hedging transactions linked to a physical commodity. Specifically, counterparties should consider including acknowledgements to the effect that:

• the parties intend that their contract be considered a "swap agreement" or a "commodity forward agreement," as defined in the Bankruptcy Code;
• regardless of whether the contract is cash-settled or settled via physical delivery of the commodity, the value of the contract is based upon changes in the value of a commodity, rather than changes in the value of costs attributable to other factors such as the packaging, marketing, transportation and servicing of the commodity; and
• the contract and related transaction are tied to the broader financial market, since the counterparties entered into the transactions to hedge against risk and further may enter into other related derivative transactions with other financial intermediaries in order to manage the risks and obligations under the contract.