Navigating The 546(e) Safe Harbor Provision

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1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: Navigating The 546(e) Safe Harbor Provision Law360, New York (December 19, 2012, 5:15 PM ET) -- Navigating section 546(e), one of the Bankruptcy Code s safe harbor provisions, requires a delicate balance of academics and practical reality. While there is scant case law directly on point, courts have provided important guidance and, generally, will defer to industry norms in determining whether agreements are forward contracts and immune from avoidance. A recent decision by the Fifth Circuit Court of Appeals MBS Management Services Inc. v. MXEnergy Electric Inc. further defines the contours of section 546(e) and offers lessons that may help companies prevent certain transfers from being clawed back. Statutory Background In adding section 546(e) to the Bankruptcy Code, Congress determined that certain protections are necessary to prevent the insolvency of one commodity or security firm from spreading to other firms and possibl[y] threatening the collapse of the affected market. [1] These amendments were meant to clarify and, in some instances, broaden the commodities market protections and to ensure that, in the case of the commodities trading industry, the contractual right to liquidate a commodities contract or forward contract may not be stayed, avoided, or limited in any bankruptcy proceeding brought under Title 11. [2] Section 546(e) provides forward contract merchants with a complete defense to avoidance claims brought by a trustee, providing, in pertinent part, that: the trustee[3] may not avoid a transfer that is a settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a forward contract merchant in connection with a forward contract... that is made before the commencement of the case. [4] To qualify for this protection, the transfer recipient must demonstrate the following elements: One of the parties to the transaction must be a forward contract merchant; The transfers must have been made in connection with forward contracts; and The transfers must be considered settlement payments. In turn, the Bankruptcy Code contains the following relevant definitions: Forward contract: A contract for the purchase, sale, or transfer of a commodity or any similar good which is presently or in the future becomes the subject of dealing in the forward contract trade with a maturity date more than two days after the date the contract is entered into.[5] Forward contract merchant: An entity the business of which consists in whole or in part of entering into forward contracts as or with merchants in a commodity or any similar good,

2 article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade.[6] Settlement payment: A preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade.[7] State of the Case Law Although section 546(e) is nearly 30 years old, few cases have meaningfully analyzed it, creating uncertainty regarding which transactions fall within the reach of 546(e) s safeguard. Recently, in MXEnergy, the Fifth Circuit considered whether section 546(e) protected payments for electricity provided under a requirements contract from avoidance as preferences.[8] In the underlying contract, the debtor s counterparty agreed to supply electricity to several apartment complexes managed by the debtor. The trustee sought to avoid a payment made to the counterparty by the debtor within the preference period, arguing that the contract was not a forward contract for the purposes of the safe harbor, because it did not specify either the quantity of electricity to be purchased or the date the electricity would be delivered on. The Fifth Circuit rejected this logic, finding that the plain language of the Bankruptcy Code draws no distinction between financial forward contracts and ordinary purchase and sale forward contracts. Overall, the case law provides important guidance: Actual delivery is expected. Forward contracts, as opposed to commodity contracts, are agreements in which the physical delivery of the subject commodity is actually expected by the parties. Purely financial contracts that do not contemplate an exchange of goods are not typically considered to be forward contracts. Thus, normal purchase and sale contracts are within the purview of section 101(25)(A) where such contracts concern the future delivery of goods that are the subject of trading in the forward contract market.[9] Future delivery is key. Forward contracts for purposes of section 546(e) and section 101(25)(A), which mature (or contemplate delivery) more than two days after execution of the contract, are specifically distinguishable from spot purchase agreements which are commonly used contracts that contemplate same-day or next-day delivery of the specified commodities.[10] However, simply because a maturity date is not specified in the agreement does not categorically exempt the contract from protection under section 546(e).[11] In MXEnergy, the Fifth Circuit held that the statutory requirements were satisfied so long as no delivery was scheduled to occur within the two day window after the contract s execution.[12] Most courts agree that fixed price and quantity terms are not required to satisfy the definition of forward contract. At least one court has required that, to be considered a forward contract, an agreement must contain fixed price (not a reference price but an actual fixed dollar amount) and quantity terms.[13] In so ruling, the court analyzed the legislative history behind section 546(e), and noted that Congress intended to reach transactions that were risk-shifting in nature, including hedging against the risk of possible fluctuations in the commodities market. Other courts, including MXEnergy, have disagreed, holding that fixed price and quantity terms are not required, so long as the contract fits within the general definition set forth in the statute or otherwise follows industry guidelines.[14] Delaware s Bankruptcy Court has referred to a U.S. Department of Energy definition of a forward contract that provides that the price may be fixed or determined by formula at the time of delivery [15] as well as the CFTC definition,

3 which does not require fixed price or quantity terms. The CFTC has stated that [t]erms may be more personalized than is the case with standardized futures contracts... A price may be agreed upon in advance, or there may be agreement that the price will be determined at the time of delivery. Settlement payment is intended to be interpreted broadly. The Bankruptcy Code broadly defines settlement payment to include a settlement payment on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade. [16] In describing just how broadly settlement payment is defined, the Third Circuit has stated that it includes transfers which are normally regarded as part of the settlement process, whether they occur on the trade date, the scheduled settlement day, or any other date in the settlement process for the particular type of transaction at hand. [17] While outside the context of forward contracts, in its well-publicized Enron Creditors Recovery Corp. v. Alfa SAB de C.V. decision, the Second Circuit ruled that settlement payment should be construed broadly, rejecting arguments that (i) the payment at issue must be a type of transfer commonly used in the securities industry; (ii) the payment must involve the transfer of title of a security; and (iii) the transfer at issue must involve the participation of a financial intermediary.[18] Practical Tips Regarding Section 546(e) Companies should consider the following steps to increase the likelihood that at-risk transfers will be exempted from avoidance under section 546(e). 1. Follow the Industry In conducting a section 546(e) analysis, courts often analyze real world market practices and procedures to determine whether a party is considered to be a forward contract merchant, a contract is a forward contract and a payment is a settlement payment. Given the Bankruptcy Code s absence of specific criteria, courts do not take a one size fits all approach to the definition of forward contracts.[19] Courts also have referenced CFTC guidelines and other industry definitions. The CFTC uniformly states that the distinguishing characteristic of a forward contract is that the parties expect to make actual delivery of the commodity with reasonable frequency. The CFTC has identified the following additional common features of forward contracts as follows: (a) they are entered into for commercial purposes related to the business of a producer, processor, fabricator, refiner or merchandiser; (b) the parties to such contracts are commercial entities capable of making and receiving delivery; (c) the terms are individually negotiated; (d) the contracts cannot be assigned without the counterparty s consent; and (e) no clearinghouse, variation margining or settlement system is involved.[20] 2. Watch the Statute While industry practices are important, courts are nonetheless bound by the statutory language governing safe harbor provisions e.g., even if the industry considers a certain contract to be a forward contract, if that contract does not have a maturity date more than two days after the date the contract was entered into a court will have a difficult time finding that the transfers are protected under section 546(e). 3. Names and Labels Matter Companies should pay attention to the forms they use in connection with forward contract transactions to ensure that they do not undermine a potential safe harbor defense. For example, labeling a contract a spot purchase agreement or including provisions in a contract that are inconsistent with rulings regarding the definition of forward contract may create problems when invoking section 546(e).

4 4. Timing Matters Although courts have broadly construed the definition of settlement payment, it is worth noting that several courts have found that where the payment is made on a significantly delinquent basis, the nature of the transfer may arguably transform a settlement payment to a delinquent obligation, and the transferee may, in turn, be considered to be a debt collector rather than a forward contract merchant for purposes of that particular transfer.[21] Relevant considerations include whether the parties entered into a debt work-out agreement, if there was litigation regarding a claim, or other collection efforts.[22] Accordingly, companies should carefully maintain their records regarding invoicing, collection efforts and correspondence concerning any late payments. 5. Internal Coordination To the extent practicable, companies operating in the commodities industry should foster communication and coordination among business groups to ensure consistency of their descriptions of various types of contracts, including forward contracts and spot purchase contracts. It is also advisable to review standard boilerplate forms in light of the relevant safe harbor rulings. MXEnergy and the other cases interpreting the safe harbor of section 546(e) provide companies with important guidance to help minimize the likelihood of an avoidance action following the bankruptcy of a counterparty. Even if a company believes that its counterparties are financially sound, the commodities business can be volatile and, as recent history has taught us, fortunes can quickly change. Taking the time to review a company s contracts can increase the chances of successfully invoking section 546(e). --By Ari M. Berman, Alexandra S. Kelly and Lance A. Mulhern, Vinson & Elkins LLP Ari Berman is a partner with Vinson & Elkins in the firm's New York office. Alexandra Kelly and Lance Mulhern are both associates in the firm's New York office. The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] H.R. REP. No , at 1 (1982), U.S. Code Cong. & Admin. News 1982, p [2] H.R. REP. No , at 2 (1982), U.S. Code Cong. & Admin. News 1982, pp [3] Williams v. Morgan Stanley Capital Group Inc. (In re Olympic Natural Gas Co.), 294 F.3d 737, 740 (5th Cir. 2002) (citing 11 U.S.C. 546(e)). [4] 11 U.S.C. 546(e). [5] 11 U.S.C. 101(25)(A) (emphasis added). [6] 11 U.S.C. 101(26). [7] 11 U.S.C. 101(51A). [8] MBS Management Services, Inc. v. MXEnergy Electric Inc. (5th Cir. Aug. 2, 2012). [9] See MXEnergy at *6-7; In re Borden Chemicals & Plastics Operating Ltd. P ship, 336 B.R. 214 (Bankr.

5 D. Del. 2006); In re Olympic Natural Gas Co., 294 F.3d 737, 741 (5th Cir. 2002) (citing Nagel v. ADM Investor Servs., Inc., 217 F.3d 436, 441 (7th Cir. 2000)) (when eventual delivery of commodity is reasonably assured, contract is a forward); CFTC v. Co Petro Marketing Group, Inc., 680 F.2d 573, 579 (9th Cir. 1982) (forward contract is predicated upon the expectation that delivery of the actual commodity by the seller to the original contracting buyer will occur in the future ); Grain Land Coop v. Kar Kim Farms, Inc., 199 F.3d 983, 990 (8th Cir. 1999) ( [I]t is the contemplation of physical delivery of the subject commodity that is the hallmark of an unregulated cash-forward contract. ). [10] See Borden, 336 B.R. at 224. [11] See MXEnergy at *6. [12] Id. [13] See Hutson v. M.J. Soffe Co. (In re Nat l Gas Distribs.), 412 B.R. 758, (Bankr. E.D.N.C. 2009). [14] See, e.g., MXEnergy, at *5 (finding that fixed price and quantity terms are not required because neither 546(e) nor 101(25)(A) contains such requirements); Borden, 336 B.R. at 217 (finding that the contracts at issue, which were priced based on a reference to an index and were swing contracts which feature variable quantities, were forward); McKittrick v. Nat l Fuel Mktg., No. ADV , 2011 WL at *1 (Bankr. D. Or. May 25, 2011) (finding that fixed price, quantity and performance dates are not required for a finding that an agreement is a forward contract). [15] Borden, 336 B.R. at 216 (citation omitted) [16] 11 U.S.C. 101(51A); see In re Resorts Int'l, Inc., 181 F.3d 505, 515 (3d Cir. 1999). [17] Bevill, Bresler & Schulman Asset Mgmt. Corp. v. Spencer Sav. & Loan Ass'n, 878 F.2d 742, 752 (3d Cir. 1989). [18] Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V., 651 F.3d 329, 339 (2d Cir. 2011). [19] The Fifth Circuit echoed this in MXEnergy, by stating that because forward contracts are individually negotiated and not exchange-traded, the Bankruptcy Code reasonably forewent encumbering the definition with technical requirements. MXEnergy at *7. [20] By way of comparison, the Department of Energy defines a forward contract as an agreement between two parties to buy (sell) a specified quality and quantity of a good at an agreed date in the future at a fixed price or at a price determined by formula at the time of delivery to the location specified in the contract. [21] See Newhouse v. Tex. E. Transmission Corp., (In re Aurora Natural Gas) 316 B.R. 481, 484 (Bankr. N.D. Tex. 2004). [22] GPR Holdings, L.L.C. v. Duke Energy Trading & Mrktg., LLC, Bankr. No SAF-11, SAF-7, Adv. No WL , at *4 (Bankr. N.D. Tex. May 27, 2005). All Content , Portfolio Media, Inc.