Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Restructuring & Insolvency, May, 2008
The Canadian government has recently changed how it defines eligible financial contracts. For the derivatives industry, the new definition appears to give deference to the over-the-counter commodities market in determining what is an eligible financial contract.
Since the inclusion of eligible financial contract provisions in the Companies' Creditors Arrangement Act (CCAA) in 1997, there have been two appeal level decisions in Canada reviewing and interpreting the legislation. Against this backdrop, Parliament passed legislation in June 2007 amending the legislative landscape for eligible financial contracts. In November 2007, the Eligible Financial Contact General Rules (CCAA) (the EFC General Rules) were registered. In this bulletin, we review the two appeal cases considering the prior legislation and review the changes contained in the EFC General Rules and interpret them in the context of the prior case law.
Eligible Financial Contracts – Background
In Re Blue Range Resources Corp., the first case to test the EFC provisions inserted into the CCAA in 1997, the lower court (chambers judge) was concerned that broadly defining forward contracts that qualify as EFCs would defeat the objective of the general stay under the CCAA. Blue Range Resources Corp., a producer, had forward sold gas it produced to several merchant trading companies under forward contracts with each. The merchants, asserting that their contracts were EFCs, relied on paragraphs 11.1(1)(h) and (k) of the CCAA and claimed that their contracts were forward commodity contracts or master agreements in respect of forward commodity contracts.
The chambers judge focussed on the word "financial" in the term "eligible financial contracts" as defined by s. 11.1(1) of the CCAA. The chambers judge decided that a distinction should be drawn between contracts whose purpose is to lead to the actual delivery of a commodity, which he called physical contracts, and contracts whose purpose is only financial and is not intended to lead to actual delivery of a commodity, which he called financial contracts. He found that only the latter could be eligible financial contracts and that the question of whether contracts are one or the other is to be resolved by the intention of the parties. After reviewing the contracts and noting that they contemplated physical delivery of natural gas, he concluded that they were not EFCs.
The Alberta Court of Appeal rejected the distinction between physically and financially settled contracts and instead considered the derivatives market which the legislation was intended to protect and examined what parties in that market treated as forward commodity contracts. In determining what constitutes a forward commodity contract, the Court of Appeal accepted evidence of a specialist in energy risk assessment that forward contracts include: a buyer and a seller; a defined contract term longer than one day; a defined volume; a defined delivery and receipt point and a defined price or pricing mechanism. The Court of Appeal (at para. 54) held as follows:
Eligible financial contracts in s. 11.1(1) include both physically-settled and financially-settled transactions. Restricting forward commodity contracts in s. 11.1(1)(h) to cash-settled contracts is contrary to the plain meaning of the section and inconsistent with Parliament's objective of protecting the risk management structure within the derivatives market. Nor is such a restriction necessary to achieve the purpose of the CCAA. While forward commodity contracts may be physically settled by the delivery of product, they must be restricted to contracts for fungible commodities which trade in a liquid and volatile market.
In 2004, Androscoggin Energy LLC filed for protection in the United States and sought a recognition order under s.18.6 of the CCAA in Ontario. Androscoggin was an end user of natural gas used to power various cogeneration facilities it owned. Various natural gas suppliers and marketers who were out of the money under their forward contracts with Androscoggin brought an application for a declaration that their contracts were EFCs and not subject to the CCAA stay of termination rights.
The motions judge preferred the reasoning of the lower court in the Blue Range case and found that the "essential relationship" of the natural gas suppliers with Androscoggin over the term of the agreements was for the actual physical delivery of gas and, as a result, the contracts in issue were not EFCs.
The counterparties appealed to the Ontario Court of Appeal, which agreed with the motions judge that the contracts in issue were not EFCs, but did not accept the reasoning that they were not EFCs by virtue of the fact that they called for a physical delivery. The Ontario Court of Appeal made detailed reference to the Reasons for Judgment of Fruman J.A. in Blue Range and rejected a distinction between physically settled and financially settled contracts as the basis for determining whether a contract is an EFC.
In finding that the contracts before it were not EFCs, the Ontario Court of Appeal held (at para. 15) as follows:
The contracts in issue before Fruman J.A. served a financial purpose unrelated to the physical settlement of the contracts. The reasons in Blue Range Resource Corp. indicate that the contracts Fruman J.A. examined enabled the parties to manage the risk of a commodity that fluctuated in price by allowing the counterparty to terminate the agreement in the event of an assignment in bankruptcy or a CCAA proceeding, to offset or net its obligations under the contracts to determine the value of the amount of the commodity yet to be delivered in the future, and to re-hedge its position. Unlike the contracts found to be EFCs in Blue Range Resource Corp., supra, the contracts in issue here possess none of these hallmarks and cannot be characterized as EFCs. However, mere pro forma insertion of such terms into a contract will not result in its automatic characterization as an EFC. Regard must be had to the contract as a whole to determine its character.
In our view, the above quoted paragraph misconstrues the reasons in the Blue Range case and arguably introduces a financial purpose test that was never propounded in Blue Range.
In Re Calpine Canada Energy Limited, the chambers judge considered both Blue Range and Androscoggin and found that a Call on Production agreement (COP) without fixed volume, fixed price, fixed term, offset or netting provisions was not an EFC. Although the chambers judge did not expressly endorse the financial purpose test, she did have regard to the contract as a whole to determine its character and considered the various characteristics or hallmarks of an EFC referred to in Androscoggin.
In Calpine, the court considered the floating price/lack of fixed price a factor in not characterizing the subject agreement as an EFC. However, the court reached that conclusion based, in part, on the absence of evidence that the Respondents had conducted any hedge in relation to the agreement. There was also no evidence adduced that the derivatives industry considered the agreement to be a forward contract.
In Blue Range, the Alberta Court of Appeal did not require any scrutiny of the contract to determine whether it satisfied any financial purpose. Rather, the court relied on expert evidence of what the industry considered to be forward commodity contracts. Since the subject contracts would clearly be considered by the industry to be forward commodity contracts, the Alberta Court of Appeal found that they were EFCs within the meaning of the eligible financial contracts legislation.
EFC General Rules (CCAA)
The following types of agreements are now prescribed as EFCs by section 2 of the EFC General Rules:
(a) a derivatives agreement, whether settled by payment or delivery, that
- trades on a futures or options exchange or board or other regulated market; or
- is the subject of recurrent dealings in the derivatives markets or in the over-the-counter securities or commodities markets;
(b) an agreement to
- borrow or lend securities or commodities, including an agreement to transfer securities or commodities under which the borrower may repay the loan with other securities or commodities, cash or cash equivalents;
- clear or settle securities, futures, options or derivatives transactions; or
- act as a depository for securities;
(c) a repurchase, reverse repurchase or buy-sell back agreement with respect to securities or commodities;
(d) a margin loan insofar as it is in respect of a securities account or futures account maintained by a financial intermediary;
(e) any combination of agreements referred to in any of paragraphs (a) to (d);
(f) a master agreement insofar as it is in respect of an agreement referred to in any of paragraphs (a) to (e);
(g) a master agreement insofar as it is in respect of a master agreement referred to in paragraph (f);
(h) a guarantee of, or an indemnity or reimbursement obligation with respect to, the liabilities under an agreement referred to in any of paragraphs (a) to (g); and
(i) an agreement relating to financial collateral, including any form of security or security interest in collateral and a title transfer support agreement, with respect to an agreement referred to in any of paragraphs (a) to (h).
A derivatives agreement is defined in section 1 of the EFC General Rules as:
a financial agreement whose obligations are derived from, referenced to, or based on, one or more underlying reference items such as interest rates, indices, currencies, commodities, securities or other ownership interests, credit or guarantee obligations, debt securities, climatic variables, bandwidth, freight rates, emission rights, real property indices and inflation or other macroeconomic data and includes:
- a contract for differences or a swap, including a total return swap, price return swap, default swap or basis swap;
- a futures agreement;
- a cap, collar, floor or spread;
- an option; and
- a spot or forward.
Paragraph 2(a) of the Regulations describes the two primary components of the derivatives markets. In Blue Range, the Alberta Court of Appeal (at para. 22) identified those two components as follows:
... [n]atural gas contracts trade through an exchange or board of trade in what is known as an exchange transaction, or between two negotiating parties in an off-exchange or over-the-counter transaction. [emphasis added]
Exchanges have traditionally been characterized by "pit" trading, but have recently adopted electronic trading platforms. OTC markets are organized along three different lines: a "traditional" dealer market; an electronically brokered market; and a proprietary trading platform. In this regard, see Randall Dodd, The Structure of OTC Derivatives Markets, The Financier, Vol.9, Nos. 1-4, 2002, pgs.1-2.
As yet there is no case law interpreting the recently registered EFC General Rules. Paragraph 2(a) of the EFC General Rules references both exchange traded and over-the-counter transactions which, as indicated above, are the two components of the derivatives markets. Curiously, clause 2(a)(ii) of the EFC General Rules references both the derivatives markets and the over-the-counter commodities markets. It might perhaps have been unnecessary to reference the over-the-counter commodities markets since they are a recognized subset of the derivatives markets. However, whether or not the reference is surplusage, it is now abundantly clear that if a derivatives agreement is the subject of recurrent dealings in the over-the-counter commodities markets, it is an EFC.
The language of clause 2(a)(ii) is somewhat awkward. It references a derivatives agreement that is the subject of recurrent dealings. This phraseology leaves some ambiguity about whether it is intended that the agreement itself be the subject of recurrent dealings as opposed to the transaction underlying the agreement being of a type that is the subject of recurrent dealings. If it is the agreement itself that is to be the subject of recurrent dealings, then clause 2(a)(ii) would be narrow and refer only to transactions to acquire derivatives agreements by assignment.
However, while counterparties do from time to time negotiate assignments of existing derivatives agreements, the majority of transactions that take place in the over-the-counter commodities markets involve trades relating to commodities, not assignments of already-existing commodity trading transactions.
The EFC General Rules appear to have borrowed, albeit imperfectly, "the subject of recurrent dealings" language from the U.S. Bankruptcy Code. Caution must be exercised in comparing the U.S. and Canadian legislation since there are material differences. For example, the safe harbour afforded to forward contracts under the U.S. legislation is only available if they are transacted with a "forward contract merchant" (U.S. Bankruptcy Code Section 101(26)). There is no similar requirement under Canadian legislation.
In our view, a derivatives agreement that "is the subject of recurrent dealings" in the over-the-counter commodities markets means a derivatives agreement in respect of which the underlying trade is of a type that is the subject of recurrent dealings (i.e., repeatedly transacted) in the over-the-counter commodities markets.
The definition of "derivatives agreement" in the EFC General Rules does not contain any express requirement that it meet a financial purpose test (as propounded in the Androscoggin case). A derivatives agreement includes a financial agreement whose obligations are derived from, referenced to, or based on, referenced items such as commodities and includes a forward contract. Although there has been no higher court determination of the financial purpose test propounded in the Androscoggin case, and the amended definition of EFCs in the EFC General Rules does not clarify the point, in our view, EFCs as currently defined, do not include any requirement that a forward contract serve a financial purpose unrelated to physical settlement. As long as the forward contract involves a trade of a type that is the subject of recurrent dealings in the over-the-counter commodities markets, it should be characterized as an EFC.
Based on the definition of EFCs in the legislation as it existed prior to the EFC General Rules, the Blue Range case held that forward commodity contracts that qualify as EFCs are forward contracts for fungible commodities which trade in a liquid and volatile market. There is not, as yet, any case law interpreting the EFC General Rules. Based on a plain reading of the EFC General Rules in the context of the prior case law, an agreement will qualify as an EFC where the underlying transaction is of a type that is the subject of recurrent dealings in the over-the-counter commodities markets. Whether a transaction is of a type that is the subject of recurrent dealings in the over-the-counter commodities markets, is a question of fact, not law. Those who are in the business of conducting trades in such markets should be in a position to determine whether or not a particular transaction is of a type that is the subject of recurrent dealings in the over-the-counter commodities markets.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.