Monday, February 16, 2009

Chapter 11 avoidance actions

The court of appeals for the fourth circuit has decided a potentially important case about the limits of avoidance actions in bankruptcy cases.

The decision, by a three judge panel of the 4th circuit, came down February 11, in Huston v. DuPont.

Named plaintiff Richard M. Huston is the trustee for Natural Gas Distributors LLC, a company that filed for bankruptcy more than three years ago: January 20, 2006 to be precise. He has filed complaints against more than 20 former customers of Natural Gas, including DuPont.

My astute readers have probably heard the expression "possession is 9/10ths of the law," and may have even wondered what is the other tenth. Well ... bankruptcy law is the other tenth. Avoidance actions brought by trustees present a case in which possession, even possession honestly obtained, doesn't necessarily give one title.

This is easy to understand in a simple case. Suppose an individual with a lot of debt gives me a very valuable antique car he has had sitting in his garage. I am one of his debtors, and he gives me this car as an in-kind payment to settle his account with me.

I say "thank you," and transfer the car to my garage.

The next day, this debtor declares bankruptcy.

I have taken possession of the car, and by stipulation I have done so honestly, but the trustee of the estate will file a lawsuit demanding that I return the car to the estate. He'll want to sell it, add the proceeds to the kitty with the rest of the assets of the state, and then I can stand in line with the other creditors to await liquidation and my proper share.

That is called an "avoidance" action, and that is the sort of action Huston brought against DuPont.

One of the defenses, though, to a action in avoidance is the claim that the transfer at issue was part of a "swap contract." The definition of a "swap contract" for this purpose is extraordinarily complicated, covering several dozen enumerated contracts and transactions, as well as combinations on them, options on them, and the catch-all inclusion of "similar" contracts and transactions.

The portion of the definition relevant to the NGS/DuPont transaction is that a swap includes an agreement on "a commodity index or a commodity swap, option, future, or forward agreement."

The NGS/DuPont transaction involved the sale of natural gas. There was a standard form contract, plus a series of telephone conversations and confirming e-mails between representative of the corporate parties in which they determined the price of future deliveries of natural gas to DuPont during specified time periods.

The natural gas contracts and their prices were independent of the day-to-day fluctuations of the spot markets, and indeed were intended to protect DuPontagainst the possibility of spikes on the spot markets. So was the delivery of the natural gas pursuant to these contracts in the period just prior to the bankruptcy filing anything like the delivery to me of a car by my hypothetical debtor in the situation above? Or was it in the language of the statute a "forward agreement" on a commodity, and thus a "swap"?

The bankruptcy court had originally struck down DuPont's use of the "swap agreement" defense, contending that the deal at issue wasn't a swap agreement because it was a physically settled contract, NOT something traded in the financial markets, and thus outside what Congress presumably intended to protect in the language quoted above. The district court agreed.

But the appellate court disagreed, remanding the matter for further proceedings. It has not determined as a matter of law that this was a swap agreement. But it has said that the courts below were wrong to treat the manner of settlement (physical delivery) as dispositive. In the further proceedings, the bankruptcy court is instructed to allow the customers "to attempt to demonstrate factually and legally that their natural gas supply contracts were swap agreeents...."

I think the general reasoning of the appellate decision is sound. I wish the court had gone further than it did, and had held that these WERE swap agreements, removing that issue from further consideratioon by the bankruptcy judge. IMHO the threat of avoidance claims creates a great deal of uncertainty at the micro level in the US economy at present, and may significantly worsen downturns. Avoidance claims, and the damage trustees can do with them, HAVE to be limited. And if expanding the notion of a swap agreement is what it takes to do that, let's do it.

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