Originally published in 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 in the reorganization of Androscoggin Energy LLC. In so doing they provided guidelines for determining those types of contracts that are not subject to the general stay created pursuant to Canadian insolvency legislation.
Blue Range – "Derivatives 101"
Blue Range Resources, a producer of natural gas, obtained protection under the CCAA on March 2, 1999. Blue Range had a number of longterm natural gas supply agreements with, among others, 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), namely that they were "a spot, future, forward or other commodity contract".
Mr. Justice LoVecchio felt otherwise and decided 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"). Madam Justice Fruman, speaking for the Alberta Court of Appeal, overturned Androscoggin Energy LLC – Blue Range Revisited
LoVecchio J.’s decision on the basis that restricting forward commodity contracts in s.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 (and therefore a "forward commodity contract"), the Alberta Court of Appeal found:
Like the other items in s.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 s.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 s.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 (4th) (Alta. Q.B.) ("Blue Range Chambers Decision Decision"), paragraph 44 While there were some detractors to the Blue Range Appeal Decision (particularly those that felt the eligible financial contract test used was too broad), the clarification that it provided has generally been wellreceived and new participants (including financial institutions) have entered the gas trading industry.
Androscoggin – The Lower Court’s Decision - "I Guess That’s Why They Call It The Blues"
Androscoggin operated a co-generation facility in the State of Maine and had entered into long-term gas supply contracts with each of Pengrowth Corporation, Canadian Forest Oil Ltd., and AltaGas Ltd. (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 had risen faster than what had been contemplated in the agreements, and the Alberta Parties were out of the money at the time of the Androscoggin filing.
On November 26, 2004, Androscoggin sought protection under Chapter 11 of the U.S. Bankruptcy Code in Maine. Later that same day, Androscoggin made an application to the Ontario Superior Court of Justice under section 18.6 of the CCAA and obtained a stay of proceedings.
Notwithstanding that Androscoggin’s filing for protection was an event of 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 Mr. Justice Farley on January 24, 2005 to have the gas contracts declared eligible financial contracts in order that the Alberta Parties could terminate them.
Justice Farley denied the motion on two grounds. Firstly, he preferred Justice LoVecchio’s reasoning in Blue Range, as contracts settled by physical delivery of a commodity could not be eligible financial contracts. Secondly, 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
The Androscoggin Appeal and the Intervention of ISDA – "Kind Of Blue"
The ramifications of Justice Farley’s comments had a profound impact on the parties, as well as on the derivatives industry. The Alberta Parties sought an expedited appeal because of a hearing scheduled under the Chapter 11 proceedings, on February 22, that sought to have the gas contracts assigned.
The industry sought involvement out of a concern over the first ground of Justice Farley’s reasoning. To this end, ISDA sought to intervene in the appeal to address the conflict of law that existed between Ontario and Alberta as a result of Farley J’s decision.
The concern to ISDA and its constituents was the chilling effect this conflict would have on commodity trading. The concern could manifest itself in a likely reduction in credit availability to the derivatives industry, increased capital requirements for some participants (a big concern for the financial institutions trading physical gas), as well as a negative competitive impact in that Canadian counterparties would be less attractive to foreign counterparties whose rights against a Canadian counterparty were unclear at best, and unenforceable at worst.
On February 8, 2005, Justice Feldman directed that the appeal of the Androscoggin Chambers 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 Court of Appeal on the following Monday, February 14.
The Ontario Court of Appeal released its decision on February 18, 2005. Justice Weiler, speaking for the Court, agreed with Justice Farley’s conclusion, although not his reasoning in reaching that conclusion. Of particular relief to the industry and ISDA, the Court agreed that the Alberta Court of Appeal in Blue Range was correct in not drawing a distinction between physically-settled and financiallysettled transactions as the basis for characterizing EFCs.
However, the Court noted that EFCs 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 (i) terminate the agreement in the event of a filing for protection, (ii) set off or net its obligations, and (iii) to re-hedge its position. The gas contracts subject to the appeal did not possess these "hallmarks" and were therefore not EFCs. The Court noted that the mere insertion of such provisions did not guarantee that a contract would be considered to be an EFC.
The Court of Appeal also agreed with Mr. Justice Farley that under the terms of the contracts before the Court, the Alberta Parties were not entitled to terminate them in any event.
Analysis Of The Androscoggin Appeal – DEJA "Blue"
Physical vs. Financial
One of the strongest features of the Androscoggin decision was to lay to rest the "physical" versus "financial" debate that had been re-opened when Justice Farley refused to follow the reasoning of the Alberta Court of Appeal in Blue Range.
The premise for excluding physically-settled derivative products seems to focus on the results of a review of the legislative history of EFCs. The principal submissions on the matter were made by the Canadian Bankers Association, who argued that Canada needed to have an analogous provision in its insolvency legislation to Chapter 11 of the U.S. Bankruptcy Code, 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-settled or financiallysettled to qualify. The constituent members of the CBA were (and still are) financial institutions, who aside from involvement in gold and silver trading, were not even involved in physically-settled commodity trading at that time. In addition, the energy trading markets were relatively undeveloped in the early 1990’s 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 EFC
We do not believe that the "hallmarks" of an EFC mentioned in the Court of Appeal’s decision are new or even startling. As the Court of Appeal said in Blue Range:
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 off-setting 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 set out that physically-settled EFCs must be contracts for fungible commodities which trade in a liquid and volatile market, is based on these hallmarks. The reason that these elements of the test are required is that the solvent counterparty has immediate rights (i.e. termination and netting) to mitigate its damages (by re-hedging its position) by access to a market where the commodities are traded and that determines market value in a reliable fashion.
Finally, the hallmarks suggested by the Androscoggin Appeal Decision are completely consistent with the EFC provisions found in the BIA and the CCAA. The EFC provisions do not bestow any rights upon solvent counterparties — they just prohibit reorganization proceedings from impairing certain rights of the solvent counterparty. But even then, only certain rights of a solvent counterparty are protected, primarily being termination and set-off. If the legislation only protects 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 EFC.
The off-set or netting requirement is the most thought provoking of the three hallmarks. Firstly, 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 off-set. One wonders whether a qualification on the right to net obligations (such as a "flawed asset" or "modified two-way payments" mechanism) could serve to disqualify an agreement from being an eligible financial contract.
This inquiry proceeds on the premise stated early in this commentary that the EFC 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’s 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 fully net their respective obligations such that a reorganizing debtor would not receive compensation for it in the money positions, this balance is lost.
Indeed, if the out of the money Alberta Parties in Androscoggin had been able to terminate their long term supply contracts, the effect would have been to allow them to recapture value in the spot market. Androscoggin, however, would have seen no 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 the Alberta Parties realized 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 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 EFC.
Cross Border Comparative
One factor that has remained prevalent in EFC considerations throughout their history is a desire to ensure that the derivatives market in Canada remains competitive in the international market place. Comparing the EFC exemption to the "forward contract" safe-harbour provisions under the US Bankruptcy Code is difficult and beyond the scope of this commentary. 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 EFC or a forward contract.5
The U.S. approach appears to go through a second analysis which 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 Chambers 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.
ISDA was represented at the Androscoggin Appeal by David Mann and Barbara Grossman of Fraser Milner Casgrain LLP, with assistance from the members of the firm’s Derivatives Practice Group, notably Tom Pepevnak and Bill Jenkins.
1 Re: Blue Range Resource Corp. (2000) 20 CBR (4th) 187 (Alta. C.A.) ("Blue Range Appeal Decision Decision"), reversing Blue Range Resource Corp. (1992) 12 CBR
2 Re: Androscoggin Energy LLC, Ontario Superior Court of Justice, Commercial List, Court File #04-CL-5643, dated January 24, 2005 ("Androscoggin Chambers Decision Decision"); affirmed in part by Re: Androscoggin Energy LLC, Court of Appeal for Ontario, Docket M32171 and M32055, dated February 18, 2005
("Androscoggin Appeal Decision Decision").
3 Minutes of Proceedings and Evidence of Standing Committee on Consumer and Corporate Affairs and Government Operations, September 11, 1991, p. 12:7 and 12:28.
4 Paragraph 28 of the Blue Range Appeal Decision.
5 Williams v. Morgan Stanley Capital Group, Inc. (in re Olympic Natural Gas Co.) 294 F.3d 737 (5th Cir.) 2002.
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