Vol 8 (2011) - Issue 4

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Commodity Supply Agreements are Swap Agreements: A Counterintuitive but Quite Real Safe Harbour from Preference Avoidance

I. Introduction

'Your commodity supply agreement with the debtor is a swap agreement and therefore the transfers you received cannot be avoided.' Your client may wonder at your premise as it delights in your conclusion. Sections 546(e) and (g) of the Bankruptcy Code exempt from avoidance transfers from the debtor that would otherwise be subject to preference or constructive fraudulent transfer liability.1 The exemption is based upon the relationship of such transfers to the markets for financial derivatives. The text of sections 546(e) and (g) and the Bankruptcy Code’s definitions of key terms like 'forward contract merchant', 'forward contract', 'forward contract agreement', and 'swap agreement' together constitute expansive exemptions from avoidance liability. This article examines how payments made under ordinary commodity supply agreements can fit readily within these statutory exemptions.

Section 546(e) exempts any transfer made by or to (or for the benefit of) a forward contract merchant in connection with a forward contract. Much of the scanty case law was decided under the section 546(e) exemption.

Section 546(g) exempts, among other things, transfers made by or to (or for the benefit of) a 'swap participant'. Under section 101(53B), a 'commodity forward agreement' is a 'swap agreement'. Under section 101(53C) a party to a 'swap agreement' is a 'swap participant'. Under section 546(g), a transfer to or from or for the benefit of a 'swap participant' is exempted from avoidance. No proof is required, under section 546(g), that either party to the transfer has been a forward contract merchant. As discussed below, it would appear that any transfer pursuant to a 'forward contract' or forward agreement that has a commodity as its subject matter qualifies for exemption from avoidance as a preference or a constructively fraudulent transfer. The legislative history of the relevant statutory changes and the construction of such statutes by the courts tend to validate the broad reach indicated by the language of the statute.

As discussed in detail below, the exemptions under consideration are among those provisions of the Bankruptcy Code that are intended to protect financial markets from systemic risk, in particular risks to markets in derivatives from the insolvency and bankruptcy of a party to derivative contracts. Financial derivatives are agreements that derive their value from the value of some underlying assets, which are often but not always commodities. Such agreements have themselves becomes assets traded with increasing velocity and at increasing aggregate values over the last 30 years (at least until the crash of 2008), often on an unsecured basis, both on exchanges and over the counter (among private parties). The 2008 crash in certain derivatives markets and the massive governmental responses thereto embody anxieties over systemic risk from interruptions in market flows of such transactions. Because most over the counter derivatives transactions are unsecured, the fear is of potentially catastrophic transferred failures from one firm to another.