Fourth Circuit Reverses
In re National Gas Distributors
By:
Craig Enochs,
Kevin Page,
Bruce Ruzinsky, and
Paul Vrana
On February 11, 2009, the United States Court of Appeals for the Fourth Circuit (the Court of Appeals) reversed and remanded a ruling by the
United States Bankruptcy Court for the Eastern District of North Carolina (the Bankruptcy Court) that had held that natural gas supply contracts
did not constitute "swap agreements" under the United States Bankruptcy Code (the Code) and, thus, are not protected by the Code's "safe harbor"
protections.
On December 14, 2006, the bankruptcy Trustee for National Gas Distributors, LLC (NGD) filed an avoidance action with the Bankruptcy Court relating
to three Base Contracts for Sale and Purchase of Natural Gas published by the North American Energy Standards Board (NAESB Contracts) entered into
during the year preceding NGD's bankruptcy filing. The Trustee argued that the NAESB Contracts should be avoided as fraudulent transfers because
NGD’s sales of natural gas to customers were made for less than market value at a time when NGD was insolvent. The customers argued that the
NAESB Contracts were "commodity forward agreements" which, by the Code's definition in Section 101(53B), are considered "swap agreements" not
otherwise subject to the Trustee's avoidance action pursuant to sections 546(g), 548(c), and 548(d)(2)(D) of the Code. In its May 24, 2007,
decision, the Bankruptcy Court held that the NAESB Contracts at issue were not "commodity forward agreements" under the Code because the contracts
related to the purchase and sale of physical gas were not sufficiently tied to financial markets. Specifically, the Bankruptcy Court found that
"commodity forward agreements" must be "regularly the subject of trading" in financial markets and settled by financial exchanges of differences
in commodity prices—not directly negotiated between the purchaser and seller and subject to physical delivery of the commodity.
On appeal, the Court disagreed with the Bankruptcy Court's analysis. First, the Court rejected the idea that all "swap agreements," including
"commodity forward agreements," must be traded on exchanges or financial markets. Although the Code does not define a "commodity forward
contract," the Court noted that the term "agreement" is broader than the term "contract." Thus, the Court analyzed the definition of "forward
contract" under the Code and determined that the Code does not require a "forward contract" to be traded on an exchange. Apart from the Code, the
Court looked to precedential case law (e.g., In re Olympic Natural Gas Co., 294 F.3d 737, 741 (5th Cir. 2002)), which has held that
"forward contracts" (1) do not need to be traded on an exchange or in a market and (2) may be directly negotiated between the parties.
Accordingly, the Court reasoned that a "forward agreement" need not be traded on an exchange and can be directly negotiated—as with the
NAESB Contracts at issue in the case.
Second, the Court disagreed with the Bankruptcy Court's assumption that the NAESB Contracts at issue in the case were simple supply contracts and,
thus, do not qualify as "swap agreements." The Court noted that the NAESB Contracts at issue "were part of a series of contracts by which the
customers hedged their risk of future fluctuations in the price of natural gas." Thus, even though the NAESB Contracts were not originally traded
on exchanges, they potentially could have a direct influence on the financial markets in which natural gas hedges were traded. Moreover, the
fact that the NAESB Contracts anticipated actual delivery of gas did not automatically exclude them from qualifying as a "forward agreement"
according to the Court, noting that other courts (such as the Fifth Circuit in In Re Olympic) have found that "forward contracts" may be
physically settled. Accordingly, the Court concluded that the Bankruptcy Court too narrowly defined the term "commodity forward agreement" in
analyzing the case at hand and remanded the case for further consideration.
Importantly, the Court did not explicitly disagree with the Bankruptcy's Court's initial holding that the gas supply contracts in this case are
not "swap agreements"—it merely disagreed with the Bankruptcy Court's reasoning in reaching such conclusion and, thus, remanded the case
for further proceedings "in light of the law and the facts" as set forth by the Court.
The Court did not provide a definition of "commodity forward agreement" in its decision. However, the Court identified four characteristics of a
"commodity forward agreement" that the Bankruptcy Court may find influential in reaching its determination on remand:
- a commodity forward agreement must deal with a commodity (distinguishing a commodity agreement from other supply contracts that attribute a
large portion of costs to packaging, marketing, transportation, or other similar costs)
- the agreement must provide for payment for the commodity at a "fixed" price (which presumably means an ascertainable price regardless of
whether the price is a fixed or index-based price, but this point was not clarified by the Court of Appeals) to be delivered more than two days
after the date of the agreement
- the quantity to be delivered and the timing elements in the agreement must be fixed at the time the agreement is entered into by the
parties
- "swap agreements" may include "forward contracts," which are not always tradable like other "swap agreements" readily traded on exchanges or
in financial markets
We will continue to monitor this proceeding on remand at the Bankruptcy Court. If you have any questions, please feel free to directly contact
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