Re Calpine Canada Energy Limited, 2006 ABQB 153 (Alberta Court of Queen’s Bench), February 24, 2006
An Alberta judge has ruled that an oil and gas "call on production" (COP) agreement is not an "eligible financial contract" (EFC) under the Companies’ Creditors Arrangement Act (CCAA). Madam Justice Romaine of the Court of Queen’s Bench continued a trend established in the Blue Range and Androscoggin decisions by declining to provide a "bright line" test for determining whether physical commodity contracts are EFCs. As she put it:
There may well be criticism of a broad spectrum approach to the determination of whether a contract that is otherwise on a strict interpretation of section 11.1(1) an eligible financial contract is in reality such a contract in character and in the context of the CCAA itself. Such an approach [i.e. the one adopted here] may lead to uncertainty and a greater risk of litigation, at least until a body of case law is established. With respect to such concerns, a simple test that allows the purpose of the CCAA to be undermined with respect to certain types of commodity producers and those who deal with them is not the answer. In the absence of a more refined definition of eligible financial contract, the courts and CCAA parties will have to continue to deal with the difficult nature of the issue.
Market participants may be concerned about the lack of certainty suggested by this analysis, particularly Romaine J.’s emphasis on the "fairness of result" test—which was mentioned in Blue Range but has not previously been so central to a judicial decision in this area of law.
Determining EFC status
The court’s primary focus was on whether the COP Agreement was a commodity forward contract. If it were, it would qualify as an EFC. Naturally the judge closely examined Blue Range and Androscoggin, the two leading cases on physical commodity contracts. Blue Range, also an Alberta case, was welcomed by most market participants because it made it clear that the EFC protections applied to both physically-settled and financial agreements. While it stated that not all contracts for the sale of tangible products should be protected transactions, the Blue Range court held that the relevant factor was whether the contract dealt with a "commodity" in the relatively technical sense of the word. Blue Range defined "commodity" (in this context) as something interchangeable (fungible) that would normally trade on a futures exchange or as the underlying asset in an OTC derivatives transaction. In other words, there has to be an active and "volatile" market that allowed forward commodity contracts to be marked to market and their value determined.
In addition, Blue Range noted that a forward commodity contract typically contains terms particular to, and negotiated by, the parties (as distinct from an exchange-traded contract) and that its terms—including price, delivery and receipt points, and commodity volumes—are precisely defined (e.g. there must be a defined price or pricing mechanism).
In Androscoggin, the Ontario Court of Appeal agreed that physical commodity contracts could be EFCs, but stressed the presence of termination and netting rights as primary indicators of whether the parties had a "financial purpose" in entering into the transaction.
While citing both of these appellate level decisions with approval, Romaine J. may have added an additional degree of uncertainty here by emphasizing the fairness of result test more than they had.
Why the COP Agreement wasn’t an EFC
The COP Agreement was an ancillary agreement that had been negotiated and entered into when Calpine sold certain oil and gas rights to Pengrowth. As described by the court, it provided Calpine:
…with a reoccurring right of first refusal to purchase any portion of the gas or oil produced from the lands that were sold on market terms and conditions. The agreement remains in force for as long as gas and oil are produced from the lands, unless terminated sooner by the parties. It provides for a fixed delivery point and a price for the production spelled out by reference to current market prices. It does not compel Pengrowth to produce gas or oil from the lands.
The benefit to Calpine of the agreement was that prices were determined net of tolls and consequently there was what the court referred to as a "toll" kicker. Romaine J. held that the COP Agreement was not a forward commodity contract, and therefore not an EFC, because it lacked too many of the key indicia of an EFC:
- The pricing, duration, contract quantity and delivery terms were too uncertain (pricing was calculated on the basis of market price, the term of the contract was uncertain, and Pengrowth was not required to produce anything);
- Because the pricing was not predetermined, the COP Agreement could not be marked to market (thus lacking another important indicator that a contract is an EFC);
- There were no netting provisions (Romaine J. stressed that netting rights are neither necessary nor sufficient conditions of an EFC but added nevertheless that the significant of their presence "cannot be overemphasized");
- The lack of any offsetting hedging transactions entered into by Pengrowth was in the court’s view evidence that this was not the "type of contract that is part of the forward contract trade"; and
- The fact that the COP Agreement was part and parcel of the original sale transaction and gave Calpine a "toll kicker" made it clear that it was not simply a stand-alone gas supply contract. It was burdensome to Pengrowth and beneficial to Calpine because of the toll kicker, not the fixing of any price.
Alternatively, Pengrowth argued that the transaction was a series of spot contracts. While spot agreements are listed as EFCs in s. 11.1 of the CCAA, Romaine J. insisted that the underlying purpose of the CCAA suggests that only some fall into that category—as she noted, many spot contracts have no "financial character" at all. Since spot contracts provide only for immediate physical delivery, they were unlikely to be too important in the context of the CCAA.
(The court did not consider whether the contract was a commodity option at the spot price which is a more accurate characterization than either a forward or spot contract.)
She added that the presence in the COP of a "termination upon insolvency" provision was not sufficient to elevate it into an EFC even though the absence of a similar provision had been one of the reasons for the adverse ruling in Androscoggin.
As noted above, however, it is Romaine J.’s use of the fairness of result test may be the most significant aspect of the ruling from the market participant perspective. She held that if Pengrowth were to terminate, it would benefit by being able to sell the gas without restriction, while Calpine would lose a valuable contract (because of the toll kicker presumably) without compensation, as well as a relatively secure supply of gas at market price. Continuing to stay the termination, on the other hand, would leave Pengrowth in the same position as other suppliers to goods and services to Calpine—something she considered "fair" but which might not seem that way to parties that have entered into similar agreements in the belief that they include termination rights.
Distinguishing this decision
Madam Justice Romaine’s emphasis on the fairness of result test is certainly not helpful to market participants in search of certainty. Fortunately, however, there are a hundred ways to Sunday to distinguish the COP Agreement in issue in this case from the typical gas forward or option. The fact that it was tied to the initial land sale agreement, that it included a "toll kicker", that it did not provide for the purchaser specific quantities of gas, that it was not documented under an industry standard master agreement, and that the parties were producer and end-user (not their risk management subsidiaries) were all important to the analysis. Also, this contract dealt with gas extracted from a particular parcel of land. If a financial institution or other market intermediary entered into a physical gas purchase contract or option for a fixed quantity of a gas whether at a spot or fixed price pursuant to an agreement such as a Gas EDI or ISDA master agreement, a court should characterize it as an EFC. Given the court’s comments regarding fairness, the presence of an ISDA Second Method type of calculation on termination would support the EFC characterization as well.
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