The U.S. Court of Appeals for the Fourth Circuit recently issued a decision that has the potential to have a major impact on how contracts that provide for physical delivery of commodities are treated under U.S. bankruptcy law.  

The decision in Hutson v. E.I. Dupont De Nemours & Co., et al. (In re National Gas Distributors LLC), 556 F.3d 247 (4th Cir. 2009) is a positive development for parties entering into so-called physically settled transactions (i.e., those that provide for the physical delivery of commodities) with an entity that subsequently becomes subject to a U.S. bankruptcy procedure. In essence, the decision allows for contractual close-out netting and other key safeguards for the non-debtor counterparty.  

‘Safe Harbor’

In a case of first impression, the Fourth Circuit determined that a physically settled “commodity forward agreement” may qualify as a “swap agreement” under the Bankruptcy Code, thereby falling within its so-called “safe harbor” provisions. The court determined that its holding applies 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 presumably was insolvent (thereby deemed to be “constructive fraudulent conveyances” under bankruptcy law).

The “safe harbor” provisions provide special rights to non-debtor counterparties of certain financial contracts, such as swap agreements and forward agreements. Such rights include, among other things, the exemption from certain provisions of the Bankruptcy Code’s automatic stay, including 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, nondebtor counterparties from the debtor’s or its trustee’s avoidance powers—i.e., the right to bring preferences and fraudulent conveyance claims against creditors and other third parties.

Commodity Forward Contracts

While the safe harbor provisions generally apply to “swap agreements” as broadly defined by the Bankruptcy Code, there has been considerable dispute among U.S. bankruptcy courts as to whether physically settled commodity forward contracts constitute swap agreements and thus fall within the safe harbors, or whether they simply should be treated as physical supply contracts between sellers and end-users, devoid of such protections.

The Fourth Circuit’s decision provides significant clarification and some direction to parties to such contracts.

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, 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. The trustee sought to recover from more than $4 million 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 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. In support, they cited 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.

Bankruptcy Court’s Decision

The bankruptcy court issued orders May 24, 2006 (the “Initial Orders”) that denied the customers’ motions and concluded that the contracts were not “commodity forward agreements.” Instead, the court determined the contracts were, as a matter of law, “agreements by a single end-user to purchase a commodity,” rather than swap agreements 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 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.

By comparison, the contracts at issue 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. They were joined with an amicus brief by the International Swaps and Derivatives Association.

The bankruptcy court, however, denied the motions to amend on June 20, 2007, reiterating that, as a matter of law, the contracts were not commodity forward agreements or swap agreements. The court held again that the contracts were “simple supply contracts” for the future delivery of a commodity, and thus concluded that no factual findings were mandated.

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

Fourth Circuit’s Holding

Upon appeal, the Fourth Circuit 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. The appeals court further held that the bankruptcy court orders rested upon two patently false assumptions.

First, the Fourth Circuit 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 based its rejection on the twin principles that:

(1) Every “forward contract” is a “forward agreement,” since the term “agreement” is broader than and encompasses the term “contract.”  

(2) 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 be traded in a financial market to be part of an overall hedging program.

Significantly, the Fourth Circuit 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, which also involved other transactions that were traded in financial markets.

On the basis of legislative history, case law, and common definitions of a forward agreement, the Fourth Circuit 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 Fourth Circuit noted that just as forward contracts may be physically settled, so too may forward agreements. While the Fourth Circuit 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.

Still to Come

Accordingly, we now await an outcome on remand to the bankruptcy court. The customers in the case will attempt to demonstrate factually and legally that their contracts did qualify as swap agreements and/or commodity forward agreements. If successful, 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.

Regardless of the outcome in the underlying case, the Fourth Circuit decision brings commodity forward contracts squarely within the scope and protections of the Bankruptcy Code safe harbor provisions. This is the case whether or not they are physically or cash-settled. The decision is binding on courts within the Fourth Circuit and likely to materially influence other courts considering similar issues. Practitioners and participants in the OTC derivatives markets are advised to carefully review the Fourth Circuit’s 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:

(1) The parties intend their contract to be considered a “swap agreement” or a “commodity forward agreement,” as defined in the Bankruptcy Code;  

(2) 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

(3) The contract and related transaction are tied to the broader financial market, since the counterparties entered into the transactions to hedge against risk and may enter into other related derivative transactions with other financial intermediaries to manage the risks and obligations under the contract.