BAPCPA’s least appreciated (and understood) changes, despite their enormous impact on financial markets generally, are the changes designed to strengthen and clarify the enforceability of various types of financial derivatives contracts. To provide enhanced protection to the financial services industry, Congress added or expanded the Code’s definitions for such industry staples as "forward contracts" (§101(25)), "repurchase agreements" (§101(47)), and "swap agreements" (§101(53B)). Various other Code provisions were amended or added to reflect Congress’s desire to enable a nondebtor party–without hesitation–to terminate, liquidate or accelerate its securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements or master netting agreements with the debtor. (See generally, these few pages of professor, lawyer, Code co-architect, and energy healer Ken Klee’s excellent summary of BAPCPA’s amendments to the Code’s business-related provisions).
Columbia Law professor Edward Morrison, with Columbia GSB economics legend Franklin Edwards, argue in a Winter 2005 article entitled Derivatives and the Bankruptcy Code: Why the Special Treatment? that BAPCPA’s extension of the Code’s protections for the financial services industry "to include a broader array of financial contracts, all in the name of reducing systemic risk … is a mistake." Rather, they argue, "[a] better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay [i.e., derivative contracts are rarely needed to preserve a firm’s going-concern surplus]." Still, they warn (at p.1):
There are, however, downsides to treating derivatives contracts differently (creditors, for example, would like to disguise loans as derivatives contracts). These downsides are probably not signficant, but they highlight the fragility of the Code’s treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code’s exemptions for derivatives contracts.
After BAPCPA became law, Professor Morrison teamed with Columbia LLM candidate (and now Davis Polk associate) Joerg Riegel to author another article entitled Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges. They wrote that BAPCPA did not just "eliminate longstanding uncertainty surrounding the protections available to financial contract counterparties, especially counterparties to repurchase transactions and other derivatives contracts" Rather, they observed, "the ambit of the reforms is much broader," especially because of the newly expanded definition of "swap agreement," which they termed "so broad that nearly every derivative contract is subject to the Code’s protection." (p.1). Notably, however, this conclusion was later called into question (though not expressly) by Thompson & Knight’s Rhett Campbell in a 2005 article entitled Financial Markets Contracts and BAPCPA. He wrote that "even though the definitions themselves are often nothing more than a listing of labels with little attempt at a functional definition, the legislative history shows an intent to prevent parties from obtaining the benefits of financial contracts safe harbors merely by the judicious use of labels." 79 Am. Bankr. L. J. 697, 705 (2005).
In commenting on the impact of these reforms on the bankruptcy judiciary, Morrison and Riegel concluded (pp. 4-5):
Equally important, the amendments limit judicial discretion to assess the economic substance of financial transactions, even those that resemble ordinary loans or that retire a debtor’s outstanding debt or equity. The reforms of 2005 direct judges to apply a formalistic inquiry based on industry custom: a financial transaction is a "swap," "repurchase transaction," or other protected transaction if it is treated as such in the relevant financial market….
Indeed, if anything is clear from the new Code, it is that judges are strongly discouraged from engaging in functional analysis of financial contracts. The Code’s protections encompass contracts or combinations of contracts that differ little in substance from unprotected transactions, such as secured loans. They are protected because they are recognized in financial markets as financial contracts. Any judicial effort to distinguish protected and unprotected contracts based on their "substance" is doomed to failure and can only generate significant uncertainty in the very markets the Code seeks to protect. By relying on broad market definitions, the Act gets judges out of the (largely futile) business of second-guessing financial contracts. Absent evidence of intent to defraud a debtor’s creditors, which remains ground for denying protection to payments under a financial contract, the new role of judges is to apply industry custom to financial contracts in much the same way that they would apply custom to interpret a contract under the Uniform Commercial Code.
Maybe it’s just Professor Morrison’s year of clerking for Justice Scalia that has jaded him, but most bankruptcy judges I know don’t "apply a formalistic inquiry," especially when it comes to interpreting BAPCPA! (See also, the opinions of Judge Bruce A. Markell (here and here) and the 60 pages of handouts on principles of statutory construction that the Southern District of Ohio’s Chief Bankruptcy Judge, Thomas F. Waldron, penned for last year’s NCBJ confab). In this regard, it’s worth considering the words of the Eastern District of North Carolina’s Chief Bankruptcy Judge A. Thomas Small in In re Donald, 343 B.R. 524 (Bankr. E.D.N.C. 2006) (pdf), where he had this to say about interpreting BAPCPA:
Unfortunately, the BAPCPA amendments … are confusing, overlapping, and sometimes self-contradictory. They introduce new and undefined terms that resemble, but are different from, established terms that are well understood. Furthermore, the new provisions address some situations that are unlikely to arise. Deciphering this puzzle is like trying to solve a Rubik’s Cube that arrived with a manufacturer’s defect. [Ed. Note: This one is sure to work.] Fortunately, after many twists and turns, a few patches of solid color emerge. Id. at 529.
Judge Small’s opinion last week in Hutson v. Smithfield Packing Co. (In re Nat’l Gas Distributors, LLC), 2007 WL 1531616 (Bankr. E.D.N.C. 5/24/07) (pdf) partially resolved BAPCPA’s puzzle regarding the scope of the "swap agreement" amendments to the Code surprisingly easily, but not because he "appl[ied] a formalistic inquiry." Rather, in deciding whether BAPCPA’s expanded definition of "swap agreement" to include "forward agreements" would preempt an avoidance action against a nondebtor customer who received natural gas from the debtor under a below-market commodity contract, Judge Small concluded:
As the foregoing discussion illustrates, the court cannot rely on the plain language of the statute. The term “forward agreement” is not in everyday usage, its meaning is uncertain, and the court must consider other rules of statutory interpretation.
So what did he rely on if not the "plain language of the statute"? As suggested in Judge Waldron’s outline, the legislative history, of course! Notably, that there even was some relevant legislative history to look to was itself a great surprise to Judge Small, who wrote:
A review of the relevant statute’s history is in order. See Toibb [v. Radloff], 501 U.S. at 162, 111 S.Ct. at 2200 (explaining that where the “resolution of a question of federal law turns on a statute and the intention of Congress, we look first to the statutory language and then to the legislative history if the statutory language is unclear”) (internal quotations omitted)….
The definition applicable to the issue before the court is, of course, the post-BAPCPA definition, which is more expansive. Why did Congress expand the definition of swap agreement? Legislative history is available and, in contrast to most of BAPCPA’s legislative history which merely repeats the statute, the legislative history attempts to explain why the statute was enacted and what the statute means. Unfortunately, the guidance of the legislative history itself is contradictory.
To Judge Small, the legislative history resolved the matter in the trustee’s favor in two ways. First, he noted, Congress never intended that ordinary supply agreements would be swept into the definition of "swap agreements":
Congress … clearly stated … that it did not intend for supply agreements to be swept into the realm of swap agreements. The restrictive reference to recurrent trade, taking place in the swap markets, means that Congress was focused on financial instruments that are themselves regularly the subject of trading, and did not contemplate application of this statute to a contract of the kind at issue here, which is simply an agreement by a single end-user to purchase a commodity.
Further, applying a corollary canon of statutory construction (i.e., that statutory construction is a holistic endeavor and thus a statute must be read in its context, not in isolation), Judge Small found additional reason to exclude the contract from the protections afforded "swap agreements," stating:
In construing the statute, the court also must, of course, "consider the context in which the statutory words are used because ‘[w]e do not … construe statutory phrases in isolation; we read statutes as a whole.’ Ayes v. U.S. Dep’t of Veteranas Affairs, 473 F.3d 104, 108 (4th Cir. 2006). Here, the context is readily evident: This statute is meant to protect financial markets. Though Smithfield would have the court end the inquiry with the limited language of § 101(53B)(A)(i)(VII), which provides that a swap agreement includes "a commodity index or a commodity swap, option, future or forward agreement," putting the statute in its actual, appropriate context reveals that there is much more to the statutory definition.
It is true enough that § 101(53B)(A)(i) lists numerous agreements that fall within the definition of "swap agreement." Section 101(53B)(A)(ii) provides for additional agreements or transactions that are "similar" to those referred to in § 101(53B)(A)(i) and are the subject of recurrent dealings in the swap market and are forwards, swaps, futures, or options "on one or more rates, currencies, commodities, equity securities, or other equity instruments …" The word "similar," rather than expanding the universe of agreements that come within the umbrella of swap agreements, actually limits the agreements to those that "bear[ ] a family resemblance" to the other agreements and transactions that enjoy the protections of the Bankruptcy Code. Ayes, 473 F.3d at 108. The other agreements described in § 101(53B)(A)(i) are found in financial markets. They do not include contracts between a seller and an end-user for delivery of a product that happens to be a recognized commodity.
Finally, though none of the parties raised this important reference, Judge Small hearkened back to the happier days of yore when Justice Ginsburg and Justice Scalia could find common ground, as they did in Howard Delivery Serv., Inc. v. Zurich American Ins. Co., 126 S. Ct. 2105 (2006) (pdf) (reviewed at length here), where both agreed that "plain meaning" in the bankruptcy context must be viewed through special bankruptcy bifocals. Quoting Justice Ginsburg, Judge Small concluded:
The court’s conclusion that the contract at issue is not within the definition of a swap agreement also comports with an important guiding principle for all bankruptcy courts, which was recently emphasized … in Howard Delivery, 126 S. Ct. at 2109. The Court stated that "the Bankruptcy Code aims, in the main, to secure equal distribution among creditors." In that case, the Court concluded that it was "far from clear" that an employer’s liability to provide worker’s compensation coverage came within the language of § 507(a)(5), which confers priority for contributions to an employee benefit plan arising from services rendered. 126 S. Ct. at 2116. For that reason, and because other factors also weighed against that categorization, the Court determined that "any doubt concerning the appropriate characterization … is best resolved in accord with the Bankruptcy Code’s equal distribution aim." 126 S. Ct. at 2116. Affording to the trustee the full range of his statutory avoidance powers, on the facts before the court, is in line with both the Code’s goal of equal distribution and "the complementary principle that preferential treatment of a class of creditors is in order only when clearly authorized by Congress." 126 S. Ct. at 2109.
Both parties have made solid arguments to support their positions, but it is not clear to the court that the definition of swap agreement is broad enough to cover the contract between National Gas and Smithfield. Resolution of this case, as with Howard Delivery, turns on the "essential character" of the market protection statutes at issue. 126 S. Ct. at 2113. Because the contract is not clearly within the definition of swap agreement, the court will not upset the priority scheme of the Bankruptcy Code by affording the transfers under the contract the protections afforded to swap agreements and swap participants under § 546(g), and under § 548(c) and § 548(d)(2)(D).
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From a litigation perspective, the parties’ positions were advanced through these well-crafted briefs:
The pleadings also captured the attention of the International Swaps and Derivatives Association, which filed this amicus brief in support of dismissal of the adversary complaint. Here’s a nice link from the ISDA site showing the explosion of derivative contracts in the past 20 years (from $800 billion in aggregate notional amount at the end of 1987 to $300 trillion in aggregate notional amount at the end of 2006).
An interesting aside related to whether the affidavit and report submitted by the Trustee of its expert, Claire P. Gotham, should be stricken because her conclusion that the contracts at issue were not "swap agreements" was a question of law, thus rendering her affidavit irrelevant under FRE 401. Here’s the Defendant’s motion to strike and the Trustee’s response.
The trustee also submitted this remarkable expert report of its accountant, Neal Bradsher & Taylor, documenting the depth of the fraud perpetrated by insiders that led to the Debtor’s filing.
Many thanks to Judges Waldron and Markell for permission to publish here the materials they disseminated at the 2006 NCBJ entitled: Principal Principles of Principled Decisions: Statutory Construction and BAPCPA.
9/15/08 Update: Here’s a link to my post on the Lehman bankruptcy, which is sure to test just how much of a mistake BAPCPA"s extensions of the law really were.
© Steve Jakubowski 2007