Thomas Paine would be proud of this Court’s commonsense approach to the Bankruptcy Code
In the In re FirstEnergy Solutions Corporation bankruptcy cases,[1] the court recently issued an opinion narrowing the number of situations in which a fixed-price supply agreement (used to hedge against rising input costs and constituting a “forward contract” in bankruptcy parlance) will be treated as an exception to the general rules governing “executory contracts”[2] in chapter 11 bankruptcy cases.
The “automatic stay” under section 362 of the Bankruptcy Code usually prevents a contract counterparty from terminating an executory contract without first getting court approval (i.e., relief from the automatic stay); this is true even if the contract provides it may be terminated upon the filing of bankruptcy (an “ipso facto clause” in further bankruptcy jargon). Pursuant to section 365(d)(2), the debtor can enforce the contract during the bankruptcy case (until plan confirmation) without having to decide whether to assume or reject the contract.[3] If this rule were applied to a fixed-price supply agreement with an agreed price that is favorable to the debtor (i.e., the agreed price for the input is lower than market), the debtor’s ability to assume and assign the contract obviously maximizes the value of the estate, a chief purpose of the Bankruptcy Code.[4]
But hedging agreements can be an exception to this rule. Under section 556, there is a safe harbor that allows a “forward contract merchant” to terminate a “forward contract” (assuming there are grounds to do so under state law, such as an ipso facto clause).[5] Under this exception, either party can terminate the contract without court approval. This means that a supply contract with favorable pricing for the debtor can be terminated without the debtor’s consent, diminishing (perhaps greatly) the value of the estate.
This exception exists, if the legislative history is any guide, to prevent a ripple effect in the financial markets that would cause those markets to collapse. Whether the current statutory scheme is actually needed to accomplish this goal is not clear all. What is clear is that Congress intended to decrease systemic risk in the hedge market.
In In re FirstEnergy Solutions Corporation., the bankruptcy court addressed whether a typical manufacturer (a metal forge) operating under a “run-of-the-mill” fixed-price supply agreement, a common and simple form of hedging against rising input costs,[6] should be treated like any other counterparty operating under any other executory contract or, in contrast, should be treated specially under the section 556 safe harbor.
The FirstEnergy court said “no”: not because the supply agreement was not a “forward contract” (it was), but because the counterparty – Meadville Forging Company, L.P. (“Meadville”) – was not a “forward contract merchant.” According to the Bankruptcy Code,
The term “forward contract merchant” means a Federal reserve bank, or an entity the business of which consists in whole or in part of entering into forward contracts as or with merchants in a commodity (as defined in section 761) or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade.
The FirstEnergy court ruled that Meadville was not a forward contract merchant because its business was forging metal, not entering into, or otherwise profiting from, forward contracts. This analysis seems straightforward: metal forges are not merchants of forward contracts. But to reach this conclusion, the court had to “thread the needle” presented by the statutory definition of “forward contract merchant.” On the one hand, not every “forward contract merchant” is a merchant (yep, you read that right); recall that the definitional language includes those that enter forward contracts “as or with merchants.” On the other hand, the definition requires that the party seeking forward-contract-merchant status must be at least “in part” in the business of entering into of forward contracts. So, a “forward contract merchant” need not actually be a merchant of forward contracts so long as at least part of the entity’s business is entering into forward contracts. (Clear as mud, right?)
Here is a forward contract merchant at work.
This conundrum has, unsurprisingly, led to cases focusing on one aspect of the definition to the detriment of the whole; at least that is what the FirstEnergy court seemed to think. Accordingly, the FirstEnergy court took a middle ground. Distinguishing itself from the Mirant decision out of the Northern District of Texas,[7] the FirstEnergy court refused to agree with any categorical rule that producers and end users of a product could not also be in the business of entering forward contracts for the product; otherwise everyone in the definition would be entering in to the contract “as” a merchant, making the “with merchants” language meaningless. On the other hand, the court, departing from the influential Borden decision from the District of Delaware,[8] maintained that simply being an end user (and nothing more) under a forward contract is insufficient to qualify as being a business that consists, even in part, of entering into forward contracts – “Merely entering into supply contracts as an end user of electricity is insufficient.” (Emphasis added.)
In FirstEnergy, the contract allowed Meadville to purchase all of its needed electricity for its business – manufacturing metal parts for the automotive industry – at a predetermined price: nothing more, nothing less. Other than purchasing electricity under this contract for consumption in its forging operations, Meadville had no connection to the generation, resale, storage, or marketing of electricity or forward contracts for electricity. Hence the court’s conclusion: “Meadville’s business does not consist in whole or in part of entering into forward contracts. That is not Meadville’s business at all.”
Honestly, though the underlying statute is still a mess, the FirstEnergy court seem to give about as fair a construction to the language as I can imagine. But not everyone agrees. For example, in Chapman and Cutler LLP’s summary of this case (which is excellent and thorough) the authors argue that the FirstEnergy opinion does not offer a clear and workable standard, stating:
[I]t is unclear how a contract whose goal is to minimize the cost of a good that is required to produce a company’s products is not entered into to make a profit. Every dollar that Meadville saves on electricity is additional profit from its business. Even if Meadville lost its ‘bet’ and electricity prices at the time of delivery were lower than in the CSA, this would not change the fact that it intended that the CSA would lower its costs and enhance its profits.
This criticism seems unjustified. Indeed, even the authors acknowledge the ready answer: “the FirstEnergy court appears to require that the profit come from the trade itself.” Perhaps the authors dislike such a standard; but it is certainly workable and understandable.[9] Similarly, the authors unfairly discount the FirstEnergy court’s concern that adopting the Borden approach could easily allow the section 556 exception swallow the general rule. The authors emphasize that section 556 only applies forward contracts, i.e., contracts for commodities or goods and services that are the subject of dealing “in the forward contract trade.” But, as others have pointed out, this phrase is vague and broad; indeed, some have suggested that it is entirely useless. This language accordingly does not offer any limitation sufficiently clear to mitigate the FirstEnergy court’s very real concerns that the section 556 safe harbor not be so expanded that it circumvents the Bankruptcy Code’s general principles governing executory contracts.
Indeed, under the Borden decision, essentially every forward contract is exempted from the section 362/365 structure. Think about this for utilities, such as natural gas and electricity providers, which offer a significant number of fixed rate contracts (even down to the individual consumer level).[10] These companies would not receive the benefit of the automatic stay with respect to their customer contracts so long as the customer had a profit motive to hedge input costs. This would allow customers to receive an unjustifiable windfall at the expense of the creditor body. The purpose of section 556 (preventing the collapse of one merchant from rippling through the entire market) is clearly not served by allowing the customers of a distressed utility to cancel unfavorable supply agreements at will. But that is what Borden does.
I think that the FirstEnergy court got it right and represents a step forward, not a step back, when it comes to thinking about forward contracts in bankruptcy.
[1] In re FirstEnergy Sols. Corp., No. 18-50757 (Bankr. N.D. Ohio Jan. 15, 2019).
[2] Under the most-accepted definition, an executory contract is a contract where either parties’ failure to provide complete performance would constitute a material breach that excuses the performance of the other party.
[3] The counterparty can seek a court order requiring the debtor to make this decision sooner.
[4] In contrast, if the contract is unfavorable to the debtor, the debtor can reject the contract during the cases and the resulting damages is a prepetition claim (under section 365(g)(1)), meaning there will be only a negligible impact on the debtor’s ability to reorganize.
[5] For a good discussion of definition of forward contract, click here. Section 556 states in whole:
The contractual right of a commodity broker, financial participant, or forward contract merchant to cause the liquidation, termination, or acceleration of a commodity contract, as defined in section 761 of this title, or forward contract because of a condition of the kind specified in section 365(e)(1) of this title, and the right to a variation or maintenance margin payment received from a trustee with respect to open commodity contracts or forward contracts, shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by the order of a court in any proceeding under this title. As used in this section, the term “contractual right” includes a right set forth in a rule or bylaw of a derivatives clearing organization (as defined in the Commodity Exchange Act), a multilateral clearing organization (as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991), a national securities exchange, a national securities association, a securities clearing agency, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act, or a board of trade (as defined in the Commodity Exchange Act) or in a resolution of the governing board thereof and a right, whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice.
[6] Click here for an explanation of physical and financial hedging in the power supply context.
[7] Mirant Americas Energy Marketing, L.P. v. Kern Oil & Refining Co. (In re Mirant Corp.), 310 B.R. 548, 567 (Bankr. N.D. Tex. 2004).
[8] BCP Liquidating LLC v. Bridgeline Gas Marketing, LLC (In re Borden Chemicals and Plastics Operating L.P.), 336 B.R. 214 (Bankr. D. Del. 2006). The court in Borden concluded that “Congress’s addition of the phrase ‘in whole or in part’ had the effect that ‘essentially any person that is in need of protection with respect to a forward contract in a business setting should be covered, except in the unusual instance of a forward contract between two nonmerchants who do not enter into forward contracts with merchants.’”
[9] This is the same distinction that exists between, on the one hand, an individual who takes a loan intending to use the proceeds in a (hopefully profitable) tech startup, and, on the other hand, the institutional lender who extends the loan. Both are entering into the transaction for business purposes, but only one is actually in the business of entering into lending agreements to generate a profit. In contrast, if same individual took out the loan from the institution with the intention of relending the money to third party, even if that is not the individual’s primary business, it is his business in part. In that situation both participants entered into the lending agreement in the ordinary course of their business and both are in that business (whether in whole or in part).
[10] See this for example.
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