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19 July 2005
In only the second case heard in Canada on the subject of eligible financial contracts, the Ontario Court of Appeal recently handed down a decision on the reorganization of Androscoggin Energy LLC. The decision provides guidelines to determine the types of contracts that are not subject to the general stay created pursuant to Canadian insolvency legislation.
The first case to consider this issue was the Aleberta decisions in Blue Range Resources. Blue Range Resources, a producer of natural gas, obtained protection under the Companies' Creditors Arrangements Act on March 2 1999. Blue Range had a number of long-term natural gas supply agreements with various companies including Enron, Engage and Duke Energy. These three parties sought a declaration that their supply contracts were eligible financial contracts by virtue of Section 11.1(1)(h) of the act - namely that they were "a spot, future, forward or other commodity contract".
However, Justice LoVecchio ruled that, since the master gas supply agreements were capable of being settled by physical delivery, they could not be considered eligible financial contracts.
Enron, Engage and Duke Energy appealed, and a nervous gas trading industry sought to intervene through the submissions of the International Swaps and Derivatives Association (ISDA). The Alberta Court of Appeal overturned LoVecchio's decision on the basis that restricting forward commodity contracts in Section 11.1(1)(h) to cash-settled contracts was contrary to the plain meaning of the section and inconsistent with Parliament's objective of protecting the risk management structure within the derivatives market.
In finding that the physically settled contracts under consideration in Blue Range did constitute eligible financial contracts on the basis that they were forward contracts in respect of a commodity, the Alberta Court of Appeal found that:
"Like the other items in Section 11.1(1), forward commodity contracts are financial hedges and risk management tools. Interpreting them in the context of the rest of the section requires that they share certain traits. The contracts listed in Section 11.1(1) deal with units that are the equivalent of any other unit. Therefore, commodities must be interchangeable, and readily identifiable as fungible commodities capable of being traded on a futures exchange or as the underlying asset of an over-the-counter derivative transaction. Commodities must trade in a volatile market, with a sufficient trading volume to ensure a competitive trading price, in order that the forward commodity contracts may be 'marked to market' and their value determined. This removes from the ambit of Section 11.1(1)(h) contracts for commercial merchandise and manufactured goods which neither trade on a volatile market nor are completely interchangeable for each other."(1)
While the Blue Range appeal decision had its critics - particularly those that felt the test used for eligible financial contracts was too broad - the clarification that it provided was generally well received and new participants, including financial institutions, have entered the gas trading industry.
Androscoggin operated a co-generation facility in the US state of Maine and had entered into long-term gas supply contracts with Pengrowth Corporation, Canadian Forest Oil Ltd and AltaGas Ltd (collectively referred to here as 'the Alberta parties'). The contracts were made in 1997 and called for the Alberta parties to provide set volumes of gas to Androscoggin at an agreed price for a 10-year period. In the intervening period the price of natural gas rose faster than had been contemplated in the agreements and the Alberta parties had run 'out of the money' by 2004.
On November 26 2004 Androscoggin sought protection under Chapter 11 of the US Bankruptcy Code in Maine and applied to the Ontario Superior Court of Justice under Section 18.6 of the Companies' Creditors Arrangements Act for a stay of proceedings, which was granted.
Notwithstanding that Androscoggin's filing for protection constituted default under the gas contracts, the Alberta parties could not terminate their agreements because Androscoggin continued to pay for the gas it received. In fact, Androscoggin's co-generation facility had ceased operations and Androscoggin was reselling the gas, the profit margin being its major source of revenue while under protection.
The Alberta parties brought an application before Justice Farley on January 24 2005 to have the gas contracts declared eligible financial contracts in order that they could terminate them.
Farley denied the motion on two grounds. First, he preferred LoVecchio's reasoning in Blue Range, as contracts settled by physical delivery of a commodity could not be eligible financial contracts. Second, he found that even if the gas contracts had been considered eligible financial contracts, the agreements could not be terminated by virtue of Androscoggin's continued payments for gas under the agreements.(2)
In light of Farley's comments the Alberta parties sought an expedited appeal because of a hearing scheduled under the Chapter 11 proceedings for February 22 2005 that sought to have the gas contracts assigned.
The ISDA was concerned by the effect on commodity trading of the conflict of laws between Alberta and Ontario resulting from Farley's decision and accordingly sought to intervene in the appeal. The concern could manifest itself in various ways, including:
On February 8 2005 Justice Feldman directed that the appeal of the Androscoggin decision be expedited, that all materials be filed no later than February 11 and that the Alberta parties' leave to appeal, ISDA's leave to intervene and the actual appeal itself all be heard before the Ontario Court of Appeal on February 14 2005.
The Ontario Court of Appeal released its decision on February 18 2005. Justice Weiler, speaking for the court, agreed with Farley's conclusion, but not all of his reasons. The court agreed that the Alberta Court of Appeal in Blue Range was correct in not drawing a distinction between physically settled and financially settled transactions as the basis for characterizing eligible financial contracts.
However, the court noted that eligible financial contracts must serve a financial purpose unrelated to the physical settlement of the contract - the contract should enable the parties to manage the risk of a commodity by providing for the non-defaulting counterparty to:
The gas contracts subject to the appeal did not possess these hallmarks and thus were not eligible financial contracts. The court noted that the mere insertion of such provisions did not guarantee that a contract would be considered to be an eligible financial contract.
The appeal court also agreed with Farley that under the terms of the contracts before the court, the Alberta parties were not entitled to terminate the contracts in any event.
Physical v financial
One of the key features of the Androscoggin decision was that it laid to rest the physical versus financial debate that had been re-opened when Farley refused to follow the reasoning of the Alberta Court of Appeal in Blue Range.
The premise for excluding physically settled derivative products focused on the results of a review of the legislative history of eligible financial contracts. The principal submissions on the matter were made by the Canadian Bankers Association, which argued that Canada needed to have an analogous provision in its insolvency legislation to Chapter 11 of the US Bankruptcy Code in order to permit counterparties to terminate and close out hedging contracts.(3) At that time there was no discussion about whether a transaction had to be physically or financially settled to qualify. The constituent members of the association were (and still are) financial institutions which, aside from involvement in gold and silver trading, were not involved in physically settled commodity trading at that time. In addition, the energy trading markets were relatively undeveloped in the early 1990s and, as a result, its participants did not make any submissions to the Senate Committee. Moreover, an across-the-board interpretation is difficult to justify when other types of eligible financial contracts, such as spot contracts, repurchase contracts and future and forward commodity contracts, must be settled by physical delivery.
Hallmarks of an eligible financial contract
The hallmarks of an eligible financial contract mentioned in the appeal court's decision are not new or even startling. In Blue Range the court of appeal stated that:
"Without enforceable termination and netting-out provisions, the insolvent company maintains complete control and may repudiate a contract at any time without notice. Because the non-defaulting party cannot count on performance, it cannot effectively re-hedge its risk by entering into an offsetting contract incorporating similar terms. Given the volatility of the market, the non-defaulting party is exposed to excessive and unmanageable risk."(4)
The Androscoggin hallmarks are specifically addressed in the Blue Range appeal decision. In fact, the Blue Range appeal decision, which sets out that physically settled eligible financial contracts must be contracts for fungible commodities that trade in a liquid and volatile market, is based on these hallmarks. These elements of the test are required because the solvent counterparty has immediate rights (ie, termination and netting) to mitigate its damages (by re-hedging its position) by access to a market where the commodities are traded and which determines market value in a reliable fashion.
Finally, the hallmarks suggested by the Androscoggin appeal decision are completely consistent with the eligible financial contract provisions found in the Bankruptcy and Insolvency Act and the Companies' Creditors Arrangements Act. The eligible financial contract provisions do not bestow any rights upon solvent counterparties, but merely prohibit reorganization proceedings from impairing certain rights of the solvent counterparty. However, even then only certain rights of a solvent counterparty are protected (primarily termination and setoff). If the legislation protects only the right to terminate and net out the resulting obligations, then it goes without saying that a contract would have to have these provisions to be considered an eligible financial contract.
The setoff or netting requirement is the most thought-provoking of the three hallmarks. It seems clear that it must be a provision of the agreement and not something that must, in fact, occur. Surely, for example, a master agreement with only one confirmed transaction would qualify, notwithstanding that there was no other transaction in place at the time upon which that transaction could be offset.
It must be considered whether a qualification on the right to net obligations (eg, a flawed-asset or modified two-way payments mechanism) could serve to disqualify an agreement from being an eligible financial contract.
This enquiry proceeds on the premise that the eligible financial contract provisions are designed to balance the competing interests between reorganizing debtors and the certainty of the derivatives market. True to this premise, the theoretical result of a termination by the solvent counterparty is a zero sum. In other words, if the contracts were in the money for the debtor (meaning that the spot market price is lower than the contract price), then the debtor would receive payment from the counterparty that would make up for the lower spot price. If the contracts were out of the money, then the debtor would owe an amount but would be able to sell the commodity against the now higher spot market price. In theory, losses should offset gains so the impact to the derivatives market and the reorganizing debtor are mitigated. Where a qualification exists on the ability of the parties to net fully their respective obligations such that a reorganizing debtor would not receive compensation for its 'in the money' positions, this balance is lost.
If the out-of-the-money Alberta parties in Androscoggin had been able to terminate their long-term supply contracts, they would have been able to recapture value in the spot market. However, Androscoggin would not have seen a corresponding benefit because no amount would have been payable to it. Androscoggin would have needed a specific contractual provision allowing it credit for the gains realized by the Alberta parties when they re-hedged their positions, otherwise, as the party in breach of its agreement, it had no claim against the Alberta parties.
On the other hand, there is a persuasive argument to be made that such qualifications to the parties' ability to set off are merely additional measures that were freely negotiated at the time of entering into the contact. As such they should not, in and of themselves, be sufficient on public policy grounds to disqualify a contract from being found to be an eligible financial contract.
One factor that has remained prevalent regarding eligible financial contracts throughout their history is a desire to ensure that the Canadian derivatives market remains competitive in the international marketplace.
Comparing the eligible financial contract exemption to the forward contract safe-harbour provisions under the US Bankruptcy Code is difficult and beyond the scope of this update. It appears, however, that the two systems now take the same initial approach, namely that derivatives settled by physical delivery are eligible for protection as an eligible financial contract or a forward contract.(5)
The US approach appears to go through a second analysis that requires the solvent counterparty to establish itself as a forward contract merchant. This analysis was discouraged in submissions made to the court during the Androscoggin appeal on the basis that such an approach lent itself to uncertainty when it came to assessing a counterparty's intention, particularly where it could change over the course of the contract or where it was in the context of a fully integrated energy counterparty.
Uniform Canadian Approach
The rift that was created in this area of law by the Androscoggin first instance decision had the potential of being materially disruptive to the derivatives market. The approach taken in the Androscoggin appeal decision, which adopts the law used in the province of Alberta, is a positive step for the derivatives industry and will hopefully inspire the same type of growth in the physically settled derivatives industry since Blue Range.
For further information on this topic please contact Thomas Pepevnak or David Mann at Fraser Milner Casgrain LLP by telephone (+1 403 268 7000) or by fax (+1 403 268 3100) or by email (email@example.com or firstname.lastname@example.org).
(2) Re Androscoggin Energy LLC, Ontario Superior Court of Justice, Commercial List, Court File 04-CL-5643, January 24 2005, affirmed in part by Re Androscoggin Energy LLC, Ontario Court of Appeal, February 18, 2005.
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David W Mann
Thomas F Pepevnak