In assessing credit risk, energy traders most often deal with the risk of default by other energy-related companies. There is, however, another class of counterparties that are very active in forward contracts and swaps: municipalities. Given the reports of the financial troubles encountered by New Orleans, San Diego and Pittsburgh in recent months, energy traders may also have credit risk concerns about their municipal counterparties. In the past, the Bankruptcy Code gave inadequate protection to energy trading counterparties in the event of a municipality bankruptcy. Forward contracts and swaps could not be terminated if a municipality filed for bankruptcy. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Bankruptcy Reform Law") made significant improvements to the sections of the Bankruptcy Code that govern municipality bankruptcy, particularly as they pertain to safe-harbor contracts.

Chapter 9 of the Bankruptcy Code governs bankruptcy cases by municipalities. A wide variety of entities qualify as municipalities, including cities, counties, irrigation districts and metropolitan districts for water or power and light service. As in other chapters, Chapter 9 provides an automatic stay against actions by most counterparties upon the filing of a bankruptcy petition. In earlier versions of the Bankruptcy Code, the traditional safe-harbor exceptions to the automatic stay (allowing forward contract merchants and swap participants to exercise certain of their contractual termination and liquidation rights) did not apply in Chapter 9. The Bankruptcy Reform Law sought to rectify the problem that this caused for counterparties. Now, for new municipal bankruptcies, forward contract merchants and swap participants are exempt from the automatic stay with respect to their safe-harbor contracts. Those entities are now permitted to liquidate, terminate or accelerate safe-harbor contracts.

After a Chapter 9 filing, the municipality’s bankruptcy case proceeds in a similar fashion to that of a company under Chapter 11. The debtor municipality may reject most leases and executory contracts that it determines to be burdensome (e.g., out of the money), while retaining (known as "assuming") those that are profitable. In addition, the municipality – or a trustee appointed solely for this purpose – generally may prosecute avoidance actions against entities that received certain preferential payments in the time leading up to the bankruptcy. As in other chapters, however, settlement and margin payments received by forward contract merchants and all payments received by swap participants are exempt from such avoidance actions.

Last year’s Bankruptcy Reform Law made significant improvements to the Bankruptcy Code’s treatment of safe-harbor counterparties to bankrupt municipalities. Although municipal bankruptcies have been uncommon in the past, a Chapter 9 case by a large city or county could have considerable impact on the energy trading sector. Because municipalities have entered into increasing numbers of long-term contracts that likely qualify as forward contracts or as swap agreements, the increased protection for safe-harbor contracts under Chapter 9 should be welcome to energy traders.

Energy Restructuring & Creditors’ Rights Team
Paul B. Turner, Richard G. Murphy, Jr., Thomas M. Byrne, B. Knox Dobbins, Jacob Dweck, Warren N. Davis, Daniel E. Frank, Harlan E. Murphy, Mark D. Sherrill and John M. Wingate.

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.