Transcript Early Termination and Liquidation Provisions in Energy
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Issues in the Termination and Liquidation of Gas Purchase and Sale Agreements
Craig R. Enochs, Jackson Walker L.L.P.
1401 McKinney, Suite 1900, Houston, Texas 77010 (713) 752-4200 phone (713) 752-4221 fax www.jw.com
Introduction
It is important when formulating transactions to anticipate worst-case scenarios.
If a worst-case scenario occurs, how do you minimize risk going forward and maximize the value in the transactions?
The answer is early termination and liquidation.
Early Termination and Liquidation Provisions
What is early termination and liquidation?
What are the benefits of including early termination and liquidation provisions in master agreements?
What are the mechanics of the early termination and liquidation process?
What are the limitations on early termination and liquidation provisions?
What is early termination and liquidation?
Early termination and liquidation is the process by which forward contracts and swap agreements are terminated prior to their contractual settlement date and settled at their mark-to-market value as of the date of early termination.
Early termination and liquidation is triggered by events of default.
What is a forward contract?
''forward contract'' means a contract
(other than a commodity contract)
for the purchase, sale, or transfer of a commodity
, as defined in section 761(8) of this title, or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade, or product or byproduct thereof,
with a maturity date more than two days after the date the contract is entered into
, including, but not limited to, a repurchase transaction, reverse repurchase transaction, consignment, lease, swap, hedge transaction, deposit, loan, option, allocated transaction, unallocated transaction, or any combination thereof or option thereon;
What is a forward contract?
As a general rule, gas transactions for delivery more than two days in the future are forward contracts.
What is a swap agreement?
''swap agreement'' means (a) an agreement (including terms and conditions incorporated by reference therein) which is a rate swap agreement, basis swap, forward rate agreement, commodity swap, interest rate option, forward foreign exchange agreement, spot foreign exchange agreement, rate cap agreement, rate floor agreement, rate collar agreement, currency swap agreement, cross-currency rate swap agreement, currency option, any other similar agreement (including any option to enter into any of the foregoing);
(B)
any combination of the foregoing; or
(C)
a master agreement for any of the foregoing together with all supplements;
What is a swap agreement?
In general, derivative hedge agreements are swap agreements.
Events of Default
Events of default are contractual breaches that trigger the right to terminate and liquidate the agreement.
They are occurrences that are sufficiently serious to give rise to the remedy of early termination and liquidation.
They are generally objective Example Failure to pay Failure to deliver collateral Bankruptcy Cross-default on third-party debt New types Cross-default under any obligation Default under any agreement between the parties Default under any agreement between the parties’ affiliates Diminution of guarantor’s ownership share in guaranteed party
What are the benefits of early termination and liquidation provisions?
Provide the ability to exit transactions with a counterparty that has experienced an event of default rather than waiting for the roll-off and settlement of the transactions in future months.
Reduce credit exposure to the counterparty.
Preserve the value of the terminated transactions.
Provide the ability to resolve claims with a bankrupt party outside of the bankruptcy proceeding.
Permit setoff of obligations.
Provide certainty of exposure for risk determination.
Provide an independent and precise structure to terminate and liquidate transactions without having to resort to litigation.
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate Suspend Performance Withhold Collateral
Event of Default
Terminate and Liquidate Notice and Designation of Early Termination Date Terminate Liquidation Setoff Payment
Mechanics of Early Termination & Liquidation Provisions Don’t Terminate
Do Nothing Suspend Payment Suspend Performance Withhold Collateral Event of Default Terminate and Liquidate Notice and Designation of Early Termination Date Terminate Liquidation Setoff Payment
Mechanics of Early Termination & Liquidation Provisions Do Nothing
Don’t Terminate Suspend Payment Suspend Performance Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Terminate Liquidation Setoff Payment
Why would a party choose to take no action?
If it had no exposure to the defaulting party If the non-defaulting party would owe the defaulting party the settlement amount If it believed the defaulting party was going to cure the event of default with no lasting harm to either party If it did not wish to end the trading relationship with the defaulting party If the non-defaulting party wanted to use the threat of early termination and liquidation as leverage to renegotiate the agreement
Mechanics of Early Termination & Liquidation Provisions
Do Nothing
Suspend Payment
Don’t Terminate Suspend Performance Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Terminate Liquidation Setoff Payment
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate
Suspend Performance
Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Terminate Liquidation Setoff Payment
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate Event of Default Terminate and Liquidate Notice and Designation of Early Termination Date Suspend Performance
Withhold Collateral
Terminate Delivery Return Liquidation Setoff Payment
Mechanics of Early Termination and Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Terminate
Ipso Facto Considerations
Liquidation Setoff Payment
Mechanics of Early Termination and Liquidation Provisions
Ipso Facto Provision A right contingent upon: The insolvency of a debtor and triggered before the closing of the bankruptcy case The commencement of a bankruptcy case The appointment of a trustee or custodian
Ipso Facto Provisions
Generally unenforceable Exception to this rule exists for ipso facto provisions that permit the termination and liquidation of forward contracts or swap agreements.
◬ Caution – if a transaction has a component that is a forward contract or swap agreement (e.g., a gas sales agreement) and a component that is not (e.g., a scheduling and transportation agreement), early termination and liquidation provisions could be enforceable in one agreement and not the other.
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default
Terminate and Liquidate
Withhold Collateral Notice and Designation of Early Termination Date Terminate Liquidation Setoff Payment
The Early Termination and Liquidation Process Example MMBtu $50,000 Party A Party B MMBtu $25,000 Party B: Party A: Result: Files for bankruptcy Terminates transactions Liquidates transactions Sets off $25,000.00 against $50,000.00
Party A pays Party B $25,000.00 instead of $50,000.00
Party B pays Party A $-0- instead of $25,000.00
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate Event of Default Terminate and Liquidate Suspend Performance
Notice and Designation of Early Termination Date
Withhold Collateral Terminate
Automatic Early Termination
Liquidation Setof
f
Payment
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Don’t Terminate Suspend Payment Suspend Performance Event of Default Terminate and Liquidate Notice and Designation of Early Termination Date Withhold Collateral
All Transactions Terminate Cherry Pick
Liquidation Setoff Payment
Cherry Picking
Leads to a “heads I win, tails you lose” result for the non-defaulting party Advantages: Deters breaches Incentivizes parties to avoid events of default Disadvantages: May be unenforceable Risk of tremendous losses for the defaulting party
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Terminate
Liquidation
Setoff Payment
Liquidation
Liquidation is the process by which the value of the terminated transactions is realized by the non defaulting party.
Liquidation
Date of Liquidation
Calculating Party Valuation Method Net Present Value
Liquidation
Date of Liquidation
Calculating Party
Non-defaulting Party
Third-party
Valuation Method Net Present Value
Liquidation
Date of Liquidation Calculating Party
Valuation Method
Market Quotation
Loss Net Present Value
Liquidation
Date of Liquidation Calculating Party
Valuation Method
Market Quotation
Loss
Net Present Value
Liquidation
Date of Liquidation Calculating Party Valuation Method
Net Present Value
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate Event of Default Suspend Performance Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Terminate Liquidation
Setoff
Payment
Setoff
Importance of Setoff
Extinguishes obligations Extinguishes credit risk Extinguishes market risk Extinguishes cash flow risk Avoids bankruptcy proceedings Allows the non-defaulting party to avoid receiving only a fractional amount of what is owed by the bankrupt party
Types of Setoff
Single Agreement
Cross-Product
Cross-Affiliate
Setoff – Single Agreement Party A $50,000 MMBtu $25,000 Party B Party B: Party A: Result: Files for bankruptcy Terminates transactions Liquidates transactions Sets off $25,000.00 against $50,000.00
Party A pays Party B $25,000.00 instead of $50,000.00
Party B pays $-0- instead of $25,000.00
Setoff – Cross-Product Party A Derivatives $10,000 MMBtu $50,000 Party B $25,000 Party B: Party A: Result: Files for bankruptcy Terminates transactions Liquidates transactions Sets off $35,000.00 against $50,000.00
Party A pays Party B $15,000.00 instead of $50,000.00
Party B pays $-0- instead of $35,000.00
Setoff – Triangular Cross-Affiliate Party A Derivatives
$55,000
MMBtu
$50,000
Party B
$25,000
Party A owes to Party B and Party B Affiliate
MMBtu Derivatives $50,000.00
$40,000.00
$90,000.00
Party B Affiliate Party B: Files for bankruptcy Party A: Terminates transactions Liquidates transactions Sets off $90,000.00 against $80,000.00
Party B and Party B Affiliate owe to Party A
MMBtu Derivatives $25,000.00
$55,000.00
$80,000.00
Result: Party A pays Party B and Party B Affiliate $10,000.00 instead of $90,000.00
Party B and Party B Affiliate pay Party A $-0- instead of $80,000.00
Setoff – Rectangular Cross-Affiliate Party A Oil
$55,000
MMBtu
$50,000
Party B
$25,000
Party A Oil
$7,000
Party B Affiliate Affiliate Party A and Party A Affiliate owe to Party B and Party B Affiliate
MMBtu Derivatives $50,000.00
$45,000.00
$95,000.00
•
Party B: Files for bankruptcy
•
Party A: Terminates transactions Party B and Party B Affiliate owe to Party A and Party A Affiliate
•
Liquidates transactions
•
Sets off $95,000.00 against $87,000.00
•
Result: Party A and Party A Affiliate pay Party B and Party B Affiliate $8,000.00 instead of $95,000.00
•
Party B and Party B Affiliate pay Party A and Party A Affiliate $-0- instead of $87,000.00
MMBtu Oil $25,000.00
$62,000.00
$87,000.00
Mechanics of Early Termination & Liquidation Provisions
Do Nothing Suspend Payment Don’t Terminate Event of Default Suspend Performance Terminate and Liquidate Notice and Designation of Early Termination Date Withhold Collateral Terminate Liquidation Setoff
Payment
Payment
One way
Two way
Interest
Payment
One way
Pro:
A party should not be rewarded for its breach The one-way payment incentivizes the potentially defaulting party to avoid the occurrence of an event of default The agreement of the parties should be respected even if the result seems to be unfair
Con:
One-way payment is a punishment for the defaulting party’s non performance rather than compensation for the non-defaulting party’s losses This could cause one-way payment to be unenforceable because it would be punitive rather than compensatory in nature Incentivizes pretextual events of default Two way Interest
Payment
One way
Two way
A party’s breach pursuant to an event of default should not result in that party’s loss of the benefit of the bargain so long as the non-defaulting party is kept whole.
Two-way payment is more equitable. A party cannot manage the risk that it might lose the value of its in-the money positions upon the occurrence of an event of default.
Two-way damages are more likely to be enforced with less delay, expense and inconvenience than are one-way damages.
Interest
Payment
One way
Two way
Interest
Regulatory Risk
NRG bankruptcy In battle of bankruptcy court and FERC, who possesses superior authority?
State political consideration
Conclusion
Early termination and liquidation provisions can be valuable tools Pitfalls exist Check with legal advisors