The U.S. Court of Appeals for the Fourth Circuit recently issued an opinion, reversing an earlier bankruptcy court ruling that had revived the question of whether a physical supply contract may qualify as a forward contract or swap agreement for purposes of the Bankruptcy Code. Previously, the bankruptcy court for the Eastern District of North Carolina ruled that what it termed a simple supply contract between a natural gas seller and an end-user, as a matter of law, does not constitute a swap agreement. The bankruptcy court declined to determine whether the relevant contract qualified as a forward contract, but expressed considerable doubt on that issue as well. The lower court decision resulted in uncertainty for energy traders and industrial end-users, concerning whether such parties would be able to terminate, close out or offset transactions after a counterparty bankruptcy without first seeking court approval. (For Sutherland’s analysis of the earlier bankruptcy court decision, see here.) This week’s decision by the Fourth Circuit returns some beneficial clarity to the participants in the commodity markets.  

National Gas Distributors, LLC (“National Gas”), was a small natural gas supplier that filed for bankruptcy protection in January 2006. The court appointed a Chapter 11 trustee early in the case. The trustee proceeded to file fraudulent conveyance complaints against a number of customers, alleging that National Gas sold gas at below market prices, either as part of a fraudulent scheme or in a constructively fraudulent manner. Among the defendants in the fraudulent conveyance actions were several end-users of gas, including Smithfield Packing Company (“Smithfield”) and E.I. du Pont de Nemours and Company (“Du Pont” and collectively with Smithfield, the “End Users”).  

The End Users were contractual parties with National Gas under separate Base Contracts for Sale and Purchase of Natural Gas (the “Contracts” and each a “Contract”), derived from the form agreement created by the North American Energy Standards Board. The Contracts provided for National Gas to sell natural gas to the End Users. Among the provisions of the Contract was the acknowledgment of the parties that the Contract constituted a “forward contract” for purposes of the Bankruptcy Code.  

In its answer to the fraudulent conveyance complaint, the End Users asserted a number of defenses that required the underlying contract to be a swap agreement and required the parties to be swap participants. They each filed motions to dismiss the litigation, based on those defenses. The bankruptcy court denied those motions, holding that the defenses were unavailable to the End Users because the Contracts were not swap agreements. In so ruling, the lower court concluded that as physical supply agreements by the End Users to purchase commodities, the Contracts were not among those agreements traded in financial markets that Congress intended to protect with the Bankruptcy Code’s safe harbor provisions.  

The End Users appealed the bankruptcy court’s rulings and the district court then certified the matter to the Fourth Circuit. The sole issue on appeal was whether the bankruptcy court erred in ruling that the Contracts did not qualify as swap agreements, as that term is defined in the Bankruptcy Code.

In 2005, Congress expanded the definition of swap agreement significantly. The Fourth Circuit acknowledged the difficulty of the issues created by the definition’s list of “several dozen enumerated contracts and transactions, as well as combinations of them, options on them, and similar contracts or transactions”—many of which transactions are given precise names that are not themselves defined in the Bankruptcy Code. Among the enumerated contracts and transactions that are expressly within the scope of the definition of swap agreement are:  

  • An agreement that is “a spot, same day-tomorrow, tomorrow-next, forward, or other foreign exchange or precious metals agreement,  
  • “A commodity index or a commodity swap, option, future, or forward agreement,” and  
  • An agreement that is presently the subject of dealings in swap markets and is a forward, swap, future or option on commodities.  

In the bankruptcy court litigation, the End Users emphasized that the Contracts were forward contracts, as acknowledged by the parties in the terms of the Contracts. They argued that because the definition of swap agreement encompassed “forward agreements,” the Contracts were therefore swap agreements. The bankruptcy court had disagreed, declining to equate “forward contracts” with “forward agreements.”  

The Fourth Circuit rejected that reasoning. It agreed that some distinction must exist between forward contracts and forward agreements, because the Bankruptcy Code uses each term independently. It determined, however, that the latter term is broader than the former, so that every forward contract must also be a forward agreement, even if every forward agreement need not be a forward contract. As a result of that conclusion, every forward contract must qualify as a swap agreement under the Bankruptcy Code.  

A second basis for the bankruptcy court’s ruling was that the Contracts were not traded on an exchange or otherwise in a financial market. The Fourth Circuit rejected that reasoning as well. It surveyed a number of authorities and determined that a forward contract need not be traded on exchange or in financial markets. Because forward contracts are a type of forward agreement—which is explicitly listed within the definition of swap agreement—and forward contracts are not exchange-traded contracts, the court concluded that a swap agreement need not be traded on exchange or in financial markets. In addition, the Fourth Circuit noted that the Contracts were more than “simple supply contracts,” in that they were part of the End Users’ sophisticated procedures for hedging risk of price fluctuations in the natural gas markets. In light of those conclusions, the Fourth Circuit reversed the bankruptcy court’s earlier ruling and remanded the matter back to the lower court for additional determinations. In its order remanding the issue, the Fourth Circuit did not determine whether the Contracts constitute swap agreements. It did, however, lay out some guidance as to the attributes that would make up a commodity forward agreement:  

  • The subject of the agreement must be a commodity in which “substantially all of the expected costs of performance must be attributable to the expected costs of the underlying commodity,”  
  • The contractual price of the commodity must be set at the time of contracting, and  
  • The quantity and time elements must be fixed at the time of contracting.  

The Fourth Circuit’s ruling should have broad ramifications on the energy and commodity markets. The most significant effect is that market participants again have some greater consistency and certainty regarding their protections under the Bankruptcy Code’s safe harbor provisions. This opinion is consistent with the Olympic Natural Gas decision out of the Fifth Circuit in 2002. Those are the only two cases on such issues to have reached the level of the Court of Appeals, and their consistent holdings present a reasonable consensus for lower courts to follow.