Derivative transactions and financial contracts are a critical component of the United States economy. There are three main types of derivative contracts executed in our markets: futures, options and forward contracts. Each of these instruments derives value from an underlying security or resource with focus on a possible change in its future value. These instruments can be used as speculative investments, as hedges on securities already owned, or as a means of mitigating risk on volatility within a specific industry. An essential attribute of trading in these derivatives is “the ability of the parties to value their transaction on a net basis with the counterparty and to close-out and replace the transaction in the event one party defaults.”
Prior to 1982, when one party to these types of transactions filed for relief under the Bankruptcy Code, the finality of the deal remained uncertain. This uncertainty led to a string of piece-meal amendments passed between 1982 and 1990, followed by a wholesale broadening of the bankruptcy safe harbor provisions in 2005 with the passing of the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”). “The Safe Harbor Provisions were designed ‘to ensure that the swap and forward contract financial markets are not destabilized by uncertainties regarding the treatment of their financial instruments under the Bankruptcy Code.’” Congress wanted to avoid the potentially catastrophic domino effect that might be caused by unwinding settled financial transactions. Essentially, Congress wanted the safe harbor provisions to “protect the financial markets from the destabilizing effects of bankruptcy proceedings for parties to specific commodity and financial contracts.”
While safe harbor provisions appear in many sections of the Code, this memo will focus primarily on those afforded by section 546(e) as it relates to forward contracts. In particular, the memo addresses bankruptcy court interpretations of the section with focus on the recently decided, Lightfoot v. MXEnergy, Inc. Part I of this memo analyzes sections 546(e) and 101(25) of the Code and bankruptcy courts’ scattered interpretation of ‘forward contract’ under 101(25) as it relates to 546(e). Part II addresses the trend toward expanding the scope of section 546’s protection and the evolving definition of forward contract within our courts. Finally, Part III discusses the impact of Lightfoot and the policy considerations and practical effects the holding may have for bankruptcy trustees going forward.