All businesses know that one key to profitability is risk management. Particularly in such industries as oil and natural gas, eligible financial contracts have emerged as an invaluable tool to hedge the risk associated with volatile foreign currency exchange, interest rates and commodity prices. Indeed, a large business has developed proffering over-the-counter derivatives (or ‘swaps’) and standardized exchange-traded derivatives (or ‘futures’) to do just that.
Given the purpose of the arrangement, both parties must be creditworthy and remain that way for the entire term of the contract in order for derivative and similar contracts to be effective. Therefore, one risk that must also be managed is the potential future insolvency of one or other of the parties.
Although swap and future contracts are often drafted with termination or suspension clauses that deal with insolvency, these contracts may ultimately be reviewed by a court, for example in insolvency proceedings under the Companies’ Creditors Arrangement Act (CCAA). (See the related article on derivatives entitled Mitigating Insolvency Risks in Derivatives Transactions from our publication, McCarthy Tétrault Co-Counsel: Business Law Quarterly.)
The legislative insolvency regime is designed to provide an insolvent corporation with time and the opportunity to reorganize its affairs as a viable entity. Given that objective, the stay protection afforded to insolvent corporations in CCAA proceedings (preventing creditors from pursuing their contractual remedies) is quite broad. Eligible financial contracts, however, are all drafted to provide that, upon the insolvency of one party, the other party can terminate the contract and ‘net out’ the parties’ respective positions. The CCAA exempts eligible financial contracts from the general stay provisions, but the courts will construe narrowly any such contracts to ensure that they are in fact entitled to this special protection.
This approach was confirmed in the recent Alberta case of Re Calpine Canada Energy Limited, where the court discussed the eligible financial contracts exception afforded under the CCAA.
In Calpine, the court affirmed the two-pronged test for the eligible financial contracts exception expounded by the Alberta Court of Appeal in Re Blue Range Resource Corp.: the items identified in the contract must be financial hedges and risk management tools, and the classification must produce a fair result.
The court’s current interpretation of “commodities” for the purpose of the eligible financial contracts exception limits them to “interchangeable, and readily identifiable as fungible commodities” capable of being traded as futures or swaps in a volatile market where the trading volume is such that prices are competitive and the contract may be “marked to market” with the value of the commodities determined.
This definition excludes contracts for commercial merchandise and manufactured goods that do not trade on a volatile market and are not completely interchangeable with one another.
The courts have identified some of the ‘hallmarks’ of eligible financial contracts, namely:
- they include offsetting or netting provisions;
- they are not stand-alone supply contracts;
- the supply price is not fixed or predetermined;
- the term of the contract is uncertain and undefined; and
- the volumes to be produced are uncertain and undefined.
McCarthy Tétrault Notes:
Although it is imperative that businesses carefully draft their contracts to fit within the language of the legislative definition and the characteristics espoused by the courts, the final part of the classification test centres on results. Would classifying the contract as an eligible financial contract produce an unfair result? In other words, what is the potential prejudice or advantage to the respective parties?
Businesses must not only properly draft the contract itself, but also question whether termination of the contract in the insolvency proceedings would prejudice their hedging strategy.