Examining the Limits of the Forward Contract Safe Harbor
As discussed in a recent Dechert OnPoint, section 365(e)(1) of the U.S. Bankruptcy Code provides that an executory contract of a debtor may not be terminated solely because of a provision in such contract that is conditioned on, among other things, a bankruptcy filing (the ipso facto provision). There are, however, certain exceptions to the ipso facto provision of the Bankruptcy Code, including the forward contract safe harbor under section 556 of the Bankruptcy Code.
An examination of the forward contract safe harbor has been addressed recently by the Connecticut Supreme Court in CCT Communications, Inc. v. Zone Telecom, Inc., Case No. SC 19574, Nov. 21, 2017, where the Court held that a contract for long distance telephone services was not a forward contract entitled to the protections of section 556 of the Bankruptcy Code.
Background
We previously examined the background of CCT Communications. As a refresher, here are the relevant facts. CCT Communications, Inc. (“CCT”) and Zone Telecom, Inc. (“Zone”) were parties to a purchase agreement whereby Zone purchased from CCT long distance telephone services and a circuit to place such calls through a long distance service network. The agreement included a classic ipso facto clause, providing that the agreement could be terminated by either party should the other party file for bankruptcy.
CCT filed for bankruptcy in January 2007 and in February 2007, Zone sent a letter to CCT exercising its right to terminate the agreement because of CCT’s bankruptcy filing. In November 2009, the bankruptcy court dismissed CCT’s bankruptcy petition because CCT failed to timely confirm a plan. CCT then filed an action in Connecticut state court, claiming breach of the Agreement by Zone, mainly due to Zone’s failure to pay CCT under the terms of the contract. Zone filed counterclaims alleging that CCT breached the contract by failing to provide the services required and by filing for bankruptcy. The trial court held that CCT breached the contract and awarded Zone damages. CCT appealed.
Analysis
In analyzing exceptions to the ipso facto provision, the trial court found that the agreement was not a forward contract and as a result was not carved out from the application of section 365(e)(1). The Connecticut Supreme Court affirmed the trial court’s finding that the agreement was not a forward contract.
Congress carved out an exception to the ipso facto provision with respect to “forward contract merchants” who, for reasons of public policy, are not barred from terminating a “forward contract” agreement with a debtor. Section 556 of the Bankruptcy Code provides that “[t]he contractual right of a … forward contract merchant to cause the liquidation, termination, or acceleration of a … forward contract because of [an ipso facto clause] … shall not be stayed, avoided, or otherwise limited by operation of any provision of [the Bankruptcy Code] or by the order of a court in any [bankruptcy] proceedings.” Accordingly, to qualify for the safe harbor provision of section 556, Zone had to establish that it was a forward contract merchant and that the agreement was a forward contract.
Forward contract is defined in section 101(25)(A) of the Bankruptcy Code. In sum, to be a forward contract, an agreement must have the following three elements: (i) involve the sale of a commodity or something akin to a commodity, (ii) be the subject of dealing in the forward contract trade, and (iii) have a maturity date more than two days in the future.
Zone failed to address whether the agreement was the subject of dealing in the forward contract trade, and CCT argued that “forward contract trade” is a technical term of art that can only be understood in the context of exchange-traded or similar over-the-counter commodity contracts. Surveying the relevant legislative history, the Court concluded that section 556 was not intended to protect ordinary contracts for the purchase and sale of goods, and therefore, it is limited to a class of future based financial transactions, of the type most commonly associated with the use of brokers, clearing agencies, and commodities exchanges.
The Supreme Court went on to hold that Zone failed to convince it that the contract at hand is akin to those types of contracts, or that Zone is the type of counterparty intended to be protected: (i) although Zone cited to two authorities suggesting that communication services were actively resold and traded, these authorities were from 2000 and 2003 and not during the 2006-2009 relevant time period; in fact the trial court made no findings on whether long distance services were actively traded, (ii) there was no evidence that Zone entered into the agreement primarily as a financial hedge or that long distance service rates were subject to a high degree of market price volatility, (iii) the agreement did not specify a particular quantity of goods to be delivered or at least deliverable on a particular date, (iv) it was unclear whether the services at issue were truly fungible, and (v) it was not a simple contract for the purchase and sale of a commodity product or service since the contract was a multifaceted agreement involving the outright sale of digital signal circuits and a commitment to pay a minimum monthly fee regardless of usage levels.
Conclusion
We expect courts to continue to struggle with, and parties to continue to disagree on, the scope of the forward contract safe harbor. The distinction is essentially between forwards, which are private, unregulated contracts, and futures (or “commodity” contracts), which are regulated by the Commodity Futures Trading Commission. With the terms “subject of dealing in the forward contract trade” remaining undefined, and the definition of “commodity” being expansively broad (as one commentator observed the definition of commodity encompass virtually anything that is or becomes the subject of futures trading, intangible as well as tangible, except for onions), limiting the scope of this safe harbor such that the exception does not swallow the rule, could face a continuing challenge.
