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February 12, 2009 3:26 PM

Have a Client into "Swap Agreements" and "Commodity Forward Agreements?" Read On

Posted by Zach Lowe


We've been hearing a lot about what parties might have to return money to debtors who file for bankruptcy. Until Wednesday, though, we hadn't seen a case like the one addressed by the U.S. Court of Appeals for the Fourth Circuit in a case of first impression ruling that commodities lawyers are hailing as crucial to their clients' funds.

Here's what happened: A North Carolina gas company, National Gas Distributors, went bankrupt in 2006. National Gas sold natural gas to a number of major customers, including the Smithfield Packing Company and Stadler's Country Hams, Inc.

Those customers didn't pay the market price every time they purchased gas from National Gas; rather, they agreed on prices months in advance, giving both sides a chance to hedge their bets on what might happen to the market price of gas. When gas prices shot up earlier this decade, those customers were getting a great deal: all told they saved a combined total of about $4 million, court papers show.

When National Gas went bankrupt, its trustee asked for that $4 million back. Bankruptcy rules allow for debtors to recover money they lost in some money-losing deals, even if there was no fraud involved, lawyers say. There are, however, exceptions for certain contracts linked to commodities and futures markets; after all, forcing counterparties in those deals to return profits would cause chaos in the market.

The trustee, however, claimed the National Gas contracts didn't qualify for those exceptions, since the deals were not tied to the markets in ways Congress had intended when it first drafted the exemptions and later expanded them in 2005 and 2006.

First of all, the deals didn't involve day-to-day trading on the price of gas, but were instead akin to long-term bets. Second, they involved the actual physical delivery of gas to someone who planned to use it--hardly the stuff of a complex derivative swap.

Last year, a bankruptcy judge in the U.S. District Court in North Carolina, Judge A. Thomas Small, ruled in favor of the trustee and ordered the National Gas customers to pay up.

Those businesses were aghast and appealed to the Fourth Circuit. Several heavyweights, including BP and the International Swaps and Derivatives Association, hired Am Law firms to write a series of amicus briefs telling the Fourth Circuit why the judge had gotten it wrong. (Kelley Drye and Allen & Overy led the way for the amici.) 

On Wednesday, the Fourth Circuit ruled in favor of the aggrieved National Gas customers--kind of. A three-judge panel unanimously disagreed with Small's original decision and remanded it back to him for further reflection. This, of course, raises the question of whether Small will now disavow his own ruling.

"That's the question we've been talking about all morning," says Craig Wolfe, the Kelley Drye partner who drafted an amicus for BP. "We don't know how this judge can rule (the same way) in good faith now based on what the Fourth Circuit said."

Wolfe and Josh Cohn, the Allen & Overy partner who led that firm's team on the case, say the ruling is of crucial importance to parties in commodities deals. Should Small, in essence, reverse himself, it would ensure that the number of agreements exempt from clawback rules would be broad enough to include agreements that are more loosely tied to markets. 

"The ramifications are in the hundreds of millions of dollars," Wolfe says, "or much higher."

Adds Cohn: "It's a very reassuring precedent."

E. Duncan Getchell of McGuireWoods argued the case for the aggrieved businesses. John Northen, of the North Carolina boutique Northen Blue, argued on behalf of the trustee.

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I'd say the precedent is very reassuring. The trial judge completely lost track of the theoretical justification for the very existence of futures markets: to allow producers and consumers in the underlying physical market to achieve future price predictability in the commodity. Without this tie to the physical market, the derivative contract has no social utility or benefit and is really not much more than legalized internet gambling. The irony here is that the trial court would read the bankruptcy act to protect pure speculators in the derivative market and to destroy participants in the physical; i.e., real, market who are using the derivative market for its actual purpose.

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