Canada: Managing Risk In Insolvency: A Guide To Eligible Financial Contracts

In insolvency proceedings, it can be difficult to navigate how to close out a transaction with an insolvent counterparty without suffering excessive collateral damage. One question that may arise in this process is whether a contract with the insolvent party can be relied upon. Canadian insolvency laws provide special treatment for a certain category of contracts called eligible financial contracts (EFCs). EFC classification is not always considered by parties upon contract formation (even where potentially applicable) but can greatly impact the contractual parties' rights and obligations.

In this article, we provide an overview of EFCs and their judicial interpretations, which contracting parties may want to consider for managing insolvency risks.

What you need to know

• The Bankruptcy and Insolvency Act (BIA), the Companies' Creditors Arrangement Act (CCAA) and their corresponding regulations outline which types of financial agreements are EFCs¹. A non-exhaustive list of EFC examples is provided in the regulations and updated as new types of financial contracts are developed.
• Determining which financial agreements are EFCs is not always a straightforward process, as illustrated by several cases of energy contract litigation, but courts often consider contracts holistically to determine whether the essence of any contract is to serve an underlying financial purpose.
• EFCs can help mitigate contractual liability, such as the risk of indeterminate exposure from an insolvent counterparty. However, contract terms will dictate many of the additional features of the EFC.

The benefits of an EFC in insolvency

An entity concerned that a contract counterparty may become insolvent may benefit from that contract being considered an EFC. EFC classification can limit contractual liability, as the special treatment afforded to EFCs in insolvency legislation can protect a party to an agreement from the risk of indeterminate exposure to an insolvent counterparty. If a contract is classified by a court as an EFC, the insolvent party will not be able to disclaim the contract, and a general stay of proceedings will not apply.

There is no simple way to alter a contract to ensure that it is considered an EFC. Courts assess contracts holistically to determine whether the essence of the contract is to serve an underlying financial purpose. If a contract does not have an underlying financial purpose, neither the inclusion of features common to EFCs nor a statement of intent can guarantee that a court would classify the contract as an EFC.

Definition of an EFC in legislation

The BIA and the CCAA define an EFC as "an agreement of a prescribed kind"². This definition is expanded in the BIA and CCAA regulations, which list types of financial agreements that are EFCs. For example, the regulations prescribe derivatives agreements and agreements to borrow or lend securities or commodities as EFCs for the purpose of the BIA and CCAA (a full list of prescribed types of EFCs from regulations is linked in the footnotes)³.

Judicial interpretation of EFCs

Whether commodity contracts are classified as EFCs can be a complex issue. The central question that courts consider in these cases is whether the essence of any contract is to serve an underlying financial purpose. A contract set up to hedge commodity price exposure is more likely to be found to serve a financial purpose and constitute an EFC than a simple physical supply contract which is settled at the market price.

The following indicia may also be considered in a court's determination:

The relatively limited judicial history and consideration surrounding EFCs suggests that whether a contract constitutes an EFC is not often contested. However, notable ambiguity regarding EFCs exists in the energy industry. Courts have often been tasked with finding the distinction between commodity contracts that are EFCs and those that are merely commercial supply contracts.

Physically settled contracts are not disqualified from being EFCs

In Blue Range Resource Corp., Re, the Alberta Court of Appeal (ABCA) established that EFCs can be financially settled or physically settled transactions⁴. Per the ABCA, physically settled commodity transactions may resemble regular supply contracts, but both the plain meaning of the section and the Parliament of Canada's objective of allowing for risk management within the derivatives market indicate that physically settled commodity contracts can be EFCs. This was reaffirmed in 2021 by the Court of King's Bench of Alberta (ABKB) in Bellatrix Exploration Ltd v BP Canada Energy Group⁵. The Court emphasized that EFC determination is holistic; no one factor will be determinative. In Bellatrix, the agreement was found to be an EFC even though the contract did not specify a fixed price and was not a hedging contract because the contract had other factors indicating an underlying financial purpose.

There is no language that can be inserted into an agreement to guarantee that it will be considered an EFC

The Ontario Court of Appeal (ONCA) in Androscoggin Energy LLC, Re emphasized that contracts will be assessed holistically to determine if they constitute an EFC⁶—commenting that "regard must be had to the contract as a whole to determine its character"⁷. The mere insertion of pro forma language will not be determinative, though it can be an indication of the parties' intent. The Androscoggin agreement had elements typical of an EFC; the agreement was a forward commodity contract with a fixed price. However, the ONCA found that, despite these factors, the primary thrust of the contract was for the physical supply of gas and not financial risk management and was therefore not found to be an EFC.

A note on receiverships

While there do not appear to be any cases that have ruled on EFCs in the context of a receivership, the courts may support an exception for EFCs from the general stay of proceedings⁸. In Alberta Health Services v Networc Health Inc., the ABKB held that, despite the provisions not addressing EFCs in receiverships, the same policy reasons may apply for lifting the stay⁹.

Additional considerations for contracting parties

EFCs are excluded from the operation of certain aspects of the BIA and CCAA. As mentioned earlier, if a contract is an EFC, the insolvent party is prevented from disclaiming the contract and a stay of proceedings will not apply¹⁰. Specific benefits beyond this must be represented in the contractual terms¹¹.

Depending on the contract's terms, the solvent party may use the value of the contract in setting off or netting of debts, even if there are secured creditors that would normally rank in priority¹². Further, the insolvent party may terminate the contract and close out their position to prevent exposure to unmanageable risk through the continued fluctuation of the underlying commodity's price. This added protection may make EFCs desirable for entities concerned about contract counterparties becoming insolvent. Because of the impact that contract terms have on the benefits received, an entity should ensure that any specific benefit they seek to gain is clearly represented in the EFC.

EFC classification depends more on the nature of a contract and not the use of pro forma language. It is unlikely that a contract could be converted into an EFC if the contract did not already have an underlying financial purpose and contain the indicia listed in the chart above.

Footnotes

1. Eligible Financial Contract General Rules (Bankruptcy and Insolvency Act), SOR/2007-256 s 2; Eligible Financial Contract Regulations (Companies' Creditors Arrangement Act), SOR/2007-257 s 2.

2. Bankruptcy and Insolvency Act, RSC 1985, c B-3, s 2 [BIA]; Companies' Creditors Arrangement Act, RSC 1985, c C-36, s 2(1) [CCAA].

3. Eligible Financial Contract General Rules (Bankruptcy and Insolvency Act), SOR/2007-256 s 2; Eligible Financial Contract Regulations (Companies' Creditors Arrangement Act), SOR/2007-257 s 2.

4. Blue Range Resource Corp., Re 2000 ABCA 239.

5. Bellatrix Exploration Ltd, Re 2020 CarswellAlta 350.

6. Androscoggin Energy LLC, Re 2005 CarswellOnt 589 at para 15 [Androscoggin].

7. Ibid.

8. Alberta Template Committee "Alberta Template Receivership Order Explanatory Notes" (2019) Online: https://www.albertacourts.ca/docs/default-source/qb/receivership-order-explanatory-notes-(mcm-project-changes-2018)---denton.pdf?sfvrsn=fe86ad80_4.

9. Alberta Health Services v Networc Health Inc, 2010 ABQB 373 at para 51.

10. BIA, supra 2, s 65.11(10)(a), 65.1(7); CCAA supra 2, s 32(9)(a), 34(8).

11. Androscoggin, supra 6 at para 21; Bellatrix Exploration Ltd, Re 2020 ABQB 809 at para 51; BIA, supra 2 s 65.1(9); CCAA, supra 2 s 34(8).

12. BIA, supra 2 s 65.1(9);CCAA, supra 2 s 34(8).