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Good News for those Seeking Safe-Harbor Status under the Bankruptcy Code: Fourth Circuit Rejects Narrow Definition of "Commodity Forward Agreement"

February 13, 2009

In an opinion issued on February 11, 2009, the Fourth Circuit Court of Appeals held that "commodity forward agreements" under the safe harbor provisions of the bankruptcy code include agreements that are not traded on an exchange and involve physical delivery of the commodity. Hutson v. E.I. Du Pont De Nemours & Co., Inc. (In re Nat'l Gas Distributors, LLC), No. 07-2105 (4th Cir. 2009).  The decision marks an important opinion for companies dealing with physical contracts. Qualifying for protection under the safe harbor provisions provides parties with exemptions from the automatic stay and from the trustee's (debtor's) avoidance powers. Therefore, the Fourth Circuit's refusal to restrict "commodity forward agreements" to financial agreements brings the Fourth Circuit in line with other circuit courts which have interpreted the safe harbor provisions. 

The Fourth Circuit's ruling was issued on appeal from a bankruptcy court's determination that the natural gas supply contracts between National Gas Distributors, LLC ("National Gas") and several of its customers (the "Customers") were not swap agreements because the agreements were physical and not financial (and therefore did not qualify the Customers for safe-harbor status under the bankruptcy code). The trustee in the chapter 11 bankruptcy of National Gas had brought avoidance actions against the Customers alleging that the natural gas supply contracts were avoidable as fraudulent conveyances. The Customers asserted they had a complete defense to the trustee's avoidance action because the contracts were safe-harbor "swap agreements." More specifically, the Customers claimed that the contracts were "commodity forward agreements," which are included in the definition of "swap agreements." See 11 U.S.C. § 101(53B)(A)(i)(VII). The contracts at issue consisted of a base contract for the sale and purchase of natural gas, using a standard form from the North American Energy Standards Board, and a series of emails confirming telephone conversations between representatives of the parties in which they fixed the price of future deliveries of natural gas during specified time periods. Performance of the contracts always commenced more than two days after the contract's formation and the contracts required National Gas to sell and deliver the gas and the Customers to receive and purchase the gas at the specified price, regardless of the market price of natural gas, or to pay the difference between the agreed-upon price and the market price. In re Nat'l Gas Distributors, LLC. Notably, the contracts were not transferred on exchanges and they did not involve the use of brokers or middlemen.

The bankruptcy court denied safe-harbor status to the Customers and held that the Customers' natural gas supply contracts were not "commodity forward agreements." Id. The bankruptcy court found that the safe-harbor provisions, which were enacted by Congress to protect the financial markets, did not apply to the Customer's natural gas supply contracts because they were not sufficiently related to the financial markets. On appeal, the Fourth Circuit acknowledged that Congress enacted the safe-harbor provisions to protect the financial markets, but the court also noted that Congress "substantially expanded the protections it had given to financial derivatives participants and transactions by expanding the definition of 'swap participants' and swap agreements."1 Id.

The Fourth Circuit rejected the bankruptcy court's narrow definition of a "commodity forward agreement" and in a case of first impression, and with no bankruptcy code definition, the court provided a list of non-exclusive elements that the statutory language of the bankruptcy code "appears to require" in order for a contract to qualify as a "commodity forward agreement." First, the subject of the commodity forward agreement must be a commodity. In other words, the benefits and detriments of the agreement must depend on the future fluctuations in commodity prices rather than such other factors as packaging and transportation. Second, the agreement must be a "forward agreement"i.e. the agreement must require a payment for the commodity at a price fixed at the time of contracting for delivery more than two days after the date the contract is entered into.  Third, in addition to the price element, the quantity and time elements must be fixed at the time of contracting. Fourth, swap agreements also include "forward contracts" which are not necessarily assignable. Finally, although the there must be a relationship between the commodity forward agreement and the financial markets, there is no requirement that it be traded in the financial markets. A single forward agreement between two parties may have a ripple effect if, in reliance on the agreement, either party enters into additional forward agreements. Therefore, the court noted that "a simple forward agreement may readily become tied into the broader markets that Congress aimed to protect" under the safe-harbor provisions. Id. The Court of Appeals has remanded the case to the bankruptcy court to determine, in light of these factors and considerations, whether the Customers' natural gas supply contracts are "commodity forward contracts."

The Fourth Circuit's refusal to restrict "commodity forward contracts" to those contracts that are traded on an exchange and do not involve physical delivery of the commodity, as held by the bankruptcy court, finds support from other circuits as well. The Fifth Circuit does not require "forward contracts" to be traded on an exchange or in a market.  Id. (citing In re Olympic Natural Gas Co., 294 F.3d 737, 741 (5th Cir. 2002). In addition, courts in the Second and Third Circuits have also used the term "forward agreements" when referring to non-market traded agreements. In re Nat'l Gas Distributors, LLC (citing Donoghue v. Centillium Commc'ns, Inc., No. 05 Civ. 4082 (WHP), 2006 WL 775122, at *2 (S.D.N.Y. Mar. 28, 2006); Breyer v. First Nat'l Monetary Corp., 548 F. Supp. 955, 962 (D.C.N.J. 1982). The Fourth Circuit's opinion is therefore in line with decisions from other circuits, and it provides further support for the broad applicability of the protections afforded under the safe-harbor provisions of the bankruptcy code.


1 Among the agreements now covered under the definition of "swap agreements", is "any agreement or transaction that is similar to any other agreement or transaction" that is already specifically identified under the definition of a swap agreement. 11 U.S.C. § 101(53B)(A)(ii).