On February 16, 2018, the US District Court for the Southern District of Texas issued an opinion that may prove important for non-defaulting parties to trading contracts. In an appeal arising out of the Linn Energy bankruptcy, the district court held that a party seeking to terminate a safe-harbor contract pursuant to section 556 of the Bankruptcy Code is not restricted by any time limitation, and therefore does not waive its safe-harbor rights if it fails to terminate the contract within a certain amount of time. That ruling is contrary to most existing opinions on the issue, and may ultimately serve to broaden the protections for non-defaulting parties under the Bankruptcy Code’s safe harbors.
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Berry Petroleum Company, LLC was a party to two electricity supply and capacity agreements (the Contracts) with Southern California Edison (SCE). Under those Contracts, Berry supplied SCE with electricity and capacity from its cogeneration plants in California. The initial term of the Contracts was 84 months.
On May 11, 2016, Berry—among other affiliates of Linn Energy, LLC—filed a voluntary petition for chapter 11 bankruptcy protection. The Contracts contained provisions under which Berry’s bankruptcy filing constituted an event of default, which could allow for SCE to terminate the Contracts. On July 22, 2016—72 days after the petition date—SCE filed a motion for authorization to terminate the Contracts.
Section 556 of the Bankruptcy Code arguably authorized SCE to terminate the Contracts without seeking bankruptcy court approval. That statute provides: “The contractual right of a … forward contract merchant to cause the liquidation, termination, or acceleration of a …. Forward contract because of a condition of the kind specified in section 365(e)(1) [usually a bankruptcy filing] … shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by the order of a court in any proceeding under this title.” It was uncontested that both parties were forward contract merchants and that the Contracts qualified as forward contracts.
Despite the statutory language, however, case law has imposed some time limitations on non-defaulting parties to exercise their termination rights under section 556 (as discussed more below). Most likely, those judicially created time limitations and the amount of time that had already passed account for SCE’s decision to file the motion, rather than to terminate unilaterally.
In an evidentiary hearing before the bankruptcy court, testimony established that SCE belatedly began an analysis as to whether the Contracts were “in the money” or “out of the money.” That analysis revealed that SCE was out of the money by more than $30 million. SCE therefore decided to pursue the termination of the Contracts.
The bankruptcy court denied SCE’s motion. In doing so, it emphasized case law suggesting that a termination under section 556 must be done promptly, or else the termination rights would be waived. The bankruptcy court also appeared to consider SCE’s motivation in pursuing the termination as a factor in its decision.
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The bankruptcy court’s ruling was consistent with several other rulings over the past thirty years. On at least five occasions, courts have addressed whether a counterparty can exercise termination rights after some passage of time from the petition date. The first arose with the insolvencies of Amcor Funding Corp. and Drexel Burnham Lambert Inc. When Amcor filed for bankruptcy protection in May 1988, Drexel was its broker-dealer. Soon after Drexel’s parent declared bankruptcy in February 1990, Drexel directed Amcor to transfer its account to another broker-dealer or have its positions liquidated.
When Amcor could not find a substitute broker-dealer, it sought judicial relief. The court rejected Drexel’s reliance on section 555 (an analog to section 556 for securities contracts). Although it noted that one year had passed since the Amcor petition date, the court emphasized that Drexel was motivated “exclusively by the bankruptcy of Drexel’s parent, rather than by any condition of Amcor.” The court therefore held that section 555 did not apply, because Drexel was attempting to terminate because of its own financial condition, not “a condition of the kind specified in section 365(e)(1)”—a precursor to the application of the safe harbor rights in sections 555 and 556.
The issue arose twice in the Enron bankruptcy. Enron was, allegedly a swap counterparty with Metropolitan Atlanta Rapid Transit Authority (MARTA). In a state-court declaratory judgment action, MARTA denied the validity of both the swap and a termination notice that it (by an unauthorized signatory) sent three weeks after Enron’s bankruptcy filing.
When MARTA asserted a later termination date with a more favorable mark-to-market valuation, the court concluded that section 560 (another analog for swap agreements) did not protect MARTA’s later termination, which was motivated by “MARTA’s position of uncertainty and insecurity.” Because it found that the termination was “because of some other reason,” the court refused to apply the safe harbor provisions.
More recently, the issue arose when Lehman Brothers attempted to collect funds under a swap agreement with Metavante Corp. Metavante withheld its payments, based on a contractual provision triggered by Lehman’s bankruptcy filing. The decision primarily addressed that contractual provision’s enforceability, but the court noted that too much time—one year as of the decision—had passed for section 560 to apply. The court concluded: “Metavante’s window to act promptly under the safe harbor provisions has passed, and … its failure to [terminate], at this juncture, constitutes a waiver of that right.”
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That conclusion is debatable. Two policy considerations support the Amcor/Enron/Metavante rule. As time passes, more independent factors are likely to be relevant to the decision of whether to terminate. It will be uncommon—but not inconceivable—for a counterparty to wait several months before terminating, and then to reach the decision to terminate independent of additional economic factors. Further, the safe harbor statutes aim to guard against a domino effect following a major bankruptcy. If a counterparty seeks to terminate its contract months after the bankruptcy, there is little danger of a domino effect and, therefore, the rationale for the protections is arguably inapplicable.
Nevertheless, there are also sound arguments against the Metavante rule. Significantly, it lacks support from the statutes. As noted, they provide that termination rights “shall not be … limited … by order of a court”—which seems to prohibit some of the rulings described above. Likewise, those holdings might best be limited to the unusual facts of each case.
On the appeal of the Berry/SCE issues, the district court sided with the latter arguments and with SCE. It stressed “that the statutory language does not mention the timing of termination of a contract subject to section 556 [and] the bankruptcy court’s reading of the statute erected a court imposed barrier to the plain language” of section 556. Further, it noted that because neither the Fifth Circuit nor the Supreme Court has ruled on the issue, there was no way for SCE to know of a promptness requirement.
The district court’s ruling represents a victory for a plain reading of the statute and may provide non-defaulting parties with greater flexibility in their decisions of whether to terminate. Nevertheless, the weight of authorities continues to impose some vague time limitation. Until the issue is adjudicated by a higher court, the most prudent practice will be for safe harbor parties to exercise their contractual termination rights shortly after the bankruptcy filing.