Transcript Risk Considerations for Ameren Supplier Forward Contract

NETTING AND OFFSET PRINCIPLES
IN ENERGY TRANSACTIONS
CRAIG R. ENOCHS
Jackson Walker L.L.P.
1401 McKinney, Suite 1900
Houston, Texas 77010
State Bar of Texas
24th Annual Advanced Oil Gas &
Energy Resources Law Course
October 5-6, 2006
Houston, Texas
Chapter 9
Introduction
I. Netting, Setoff, and Recoupment
II. Treatment in Bankruptcy
III. Treatment in Energy Commodity
Contracts
IV. Treatment in Joint Operating
Agreement
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I. Netting, Setoff, and Recoupment
A. Netting
1. Net all transactions to a single amount
2. Usually bilateral and determined by discussions
between the parties in advance
3. Single agreement
4. Routine, recurring procedure
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I. Netting, Setoff, and Recoupment
A. Netting
5. One payment is made
6. Benefits:
• Convenience
• Efficiency
• Reduces the number of invoices and payments
7. Bookouts
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I. Netting, Setoff, and Recoupment
A. Netting
Example:
Party A and Party B are Parties to a NAESB.
Under the NAESB:
•Party A owes $1,000,000
•Party B owes
$250,000
Result:
Party A pays Party B $750,000
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I. Netting, Setoff, and Recoupment
B. Setoff
1. Sometimes referred to as “offset”
2. A creditor’s right to reduce the amount of a debt
by the amount the creditor owes the debtor
3. Any excess will still be owed to the creditor
4. Usually unilateral and communicated by notice
from one party to the other
5. Usually arises when contractual relationship ends
and debtor can’t or won’t pay
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I. Netting, Setoff, and Recoupment
B. Setoff
6. Arose under common law
7. One contract or multiple contracts
•
Setoff across affiliates may not be enforceable
8. Benefits
•
•
•
Extinguishes obligations without further action
Eliminates credit risk to the extent of the setoff
Eliminates cash flow risk
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I. Netting, Setoff, and Recoupment
B. Setoff
1.Single Agreement
Party A
MMBtu
$50,000
$25,000
Party B:
Files for bankruptcy
Party A:
Terminates transactions
Liquidates transactions
Party B
Result:
With Single Agreement Setoff
Party A pays $25,000
Party B pays $-0-
Without Setoff
Party A pays $50,000
Party B pays $25,000 in bankruptcy
dollars
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I. Netting, Setoff, and Recoupment
B. Setoff
2. Cross-Product
Power
$10,000
Party A
MMBtu
$50,000
Party B
$25,000
Party B:
Files for bankruptcy
Party A:
Terminates transactions
Liquidates transactions
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I. Netting, Setoff, and Recoupment
B. Setoff
2. Cross-Product
Party A
Power
$10,000
MMBtu
$50,000
$25,000
Party B
Result:
With Cross-Product Setoff
Party A pays $15,000
Party B pays $-0-
With Single-Agreement Setoff
Party A pays $25,000 and Party B
pays $10,000 in bankruptcy dollars
Without Setoff
Party A pays $50,000 and Party B
pays $35,000 in bankruptcy dollars
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I. Netting, Setoff, and Recoupment
B. Setoff
3. Triangular Cross-Affiliate/Cross-Product
Party A
Power
$55,000
MMBtu
$50,000
Party B
$25,000
Party B
Affiliate
Party A owes to Party B
and Party B Affiliate
Party B and Party B Affiliate
file for bankruptcy
MMBtu
$50,000.00
Party A:
Terminates transactions
Power
$40,000.00
Liquidates transactions
$90,000.00
Party B and Party B Affiliate
owe to Party A
MMBtu
Power
$25,000.00
$55,000.00
$80,000.00
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I. Netting, Setoff, and Recoupment
B. Setoff
3. Triangular Cross-Affiliate/Cross-Product
Power
$55,000
Party A
MMBtu
$50,000
$25,000
Party B
Party B
Affiliate
Result:
With Triangular Cross-Affiliate/
Cross-Product Setoff
Party A pays Party B and Party B Affiliate
$10,000
Party B and Party B Affiliate pay Party A
$-012
I. Netting, Setoff, and Recoupment
B. Setoff
3. Triangular Cross-Affiliate/Cross-Product
Power
$55,000
Party A
MMBtu
$50,000
Party B
$25,000
Party B
Affiliate
With Cross-Product Setoff
Party A pays Party B $-0Party A pays Party B Affiliate $40,000
Party B pays Party A $30,000 in bankruptcy dollars
With Single Agreement Setoff
Party A pays Party B $25,000
Party A pays Party B Affiliate $40,000
Party B pays A $55,000 in bankruptcy dollars
With No Setoff
Party A pays Party B $50,000
Party A pays Party B Affiliate $40,000
Party B pays Party A $80,000 in bankruptcy dollars
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I. Netting, Setoff, and Recoupment
B. Setoff
4. Rectangular Cross-Affiliate/Cross-Product
Derivatives
$55,000
MMBtu
$50,000
$25,000
Party A
Party B
Derivatives
$7,000
Party A
Party B
Affiliate
Affiliate
Party A and Party A
Affiliate owe to Party B
and Party B Affiliate
MMBtu
$50,000.00
Power
$45,000.00
$95,000.00
•Party B: Files for bankruptcy
•Party A:
- Terminates transactions
- Liquidates transactions
Party B and Party B
Affiliate owe to Party A
and Party A Affiliate
MMBtu
Derivatives
$25,000.00
$62,000.00
$87,000.00
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I. Netting, Setoff, and Recoupment
B. Setoff
4. Rectangular Cross-Affiliate/Cross-Product
Derivatives
$55,000
MMBtu
$50,000
$25,000
Party A
Party B
Derivatives
$7,000
Party A
Party B
Affiliate
Affiliate
Result:
With Rectangular Cross-Affiliate/
Cross-Product Setoff
Party A and Party A Affiliate pay Party B
and Party B Affiliate $8,000.00
Party B and Party B Affiliate pay Party A
and Party A Affiliate $-0-
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I. Netting, Setoff, and Recoupment
B. Setoff
4. Rectangular Cross-Affiliate/Cross-Product
Derivatives
$55,000
MMBtu
$50,000
$25,000
Party A
Party B
Derivatives
$7,000
Party A
Party B
Affiliate
Affiliate
Result:
With Triangular CrossAffiliate/Cross-Product Setoff
Party A and Party A Affiliate pay Party B $-0Party B pays Party A and Party A Affiliate $25,000
in bankruptcy dollars
Party A and Party A Affiliate pay Party B Affiliate
$33,000 Party B Affiliate pays $-016
I. Netting, Setoff, and Recoupment
B. Setoff
4. Rectangular Cross-Affiliate/Cross-Product
Derivatives
$55,000
MMBtu
$50,000
$25,000
Party A
Party B
Derivatives
$7,000
Party A
Party B
Affiliate
Affiliate
Result:
With Cross-Product Setoff
Party A pays Party B $-0Party A Affiliate pays Party B $5,000
Party B pays Party A $30,000 in bankruptcy dollars
Party A pays Party B Affiliate $40,000
Party B Affiliate pays Party A Affiliate $7,000 in
bankruptcy dollars
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I. Netting, Setoff, and Recoupment
B. Setoff
4. Rectangular Cross-Affiliate/Cross-Product
Derivatives
$55,000
MMBtu
$50,000
$25,000
Party A
Party B
Derivatives
$7,000
Party A
Party B
Affiliate
Affiliate
Result:
With Single Agreement Setoff
Party A pays Party B $25,000
Party B pays Party A $55,000 in bankruptcy dollars
Party A pays Party B Affiliate $40,000
Party A Affiliate pays Party B $5,000
Party B Affiliate pays Party A Affiliate $7,000 in
bankruptcy dollars
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I. Netting, Setoff, and Recoupment
B. Setoff
4. Rectangular Cross-Affiliate/Cross-Product
Derivatives
$55,000
MMBtu
$50,000
$25,000
Party A
Party B
Derivatives
$7,000
Party A
Party B
Affiliate
Affiliate
Result:
Without Setoff
Party A pays Party B $50,000
Party B pays Party A $80,000 in bankruptcy dollars
Party A pays Party B Affiliate $40,000
Party A Affiliate pays Party B $5,000
Party B Affiliate pays Party A Affiliate $7,000 in
bankruptcy dollars
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I. Netting, Setoff, and Recoupment
B. Setoff
4. Rectangular Cross-Affiliate/Cross-Product
•Problems
•Binding all affiliates
•All must sign
•Must state joint and several liability
•Setting off when not all affiliates are bankrupt
•Allocating net proceeds across the bankrupt affiliates
•Open issue with no case law
•Dynegy v. Enron – oral arguments 10/31/06
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I. Netting, Setoff, and Recoupment
C. Recoupment
1. A right of a defendant to reduce a plaintiff’s
damages because of a plaintiff’s breach of
contract or duty in the same transaction
2. Defensive right
•
•
Limited to same transaction as plaintiff’s claim
Limited to amount of plaintiff’s claim
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I. Netting, Setoff, and Recoupment
C. Recoupment
3. Recoupment is available in contract or at
common law
4. Bankruptcy
•
•
Recoupment is a defense, not a claim, so it does not
constitute a claim or preference
Recoupment permits a creditor to reduce prepetition
debts by post petition amounts due to the debtor
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II. Treatment in Bankruptcy
A. The Automatic Stay
1. Arises when a bankruptcy petition is filed
2. Automatic stay prohibits actions including:
•
•
•
•
•
•
Filing or continuing suit on a pre-petition action
Enforcing a pre-petition judgment
Acting to obtain possession or exercise control over property of
the estate
The setoff of pre-petition debts
Debtor’s payment of pre-petition obligations
The termination of contracts with the debtor
3. The automatic stay protects debtors from creditors and
creditors from each other
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II. Treatment in Bankruptcy
B. Safe Harbor Rights
1. Forward contracts, swap agreements and financial
participants receive an exemption to the automatic stay
•
•
•
•
Exemption is referred to as “safe harbor rights”
Must be forward contract merchants, swap participants or
financial participants
Forward contracts are contracts for the purchase or sale of a
commodity more than two days after the contract is entered into,
including options, security agreements related to such
transactions, and master agreements. (11 USC §101(25))
Forward contract merchants are entities whose business involves
entering into forward contracts (11 USC §101(26))
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II. Treatment in Bankruptcy
B.
Safe Harbor Rights
1.
Forward contracts and swap agreements receive an exemption to the
automatic stay
•
•
•
•
•
•
Swap agreements are essentially financial derivative transactions, including
options or master agreements for derivatives, similar agreements, and security
agreements for such transactions. (11 USC §101(53B))
A swap participant is “an entity that, at any time before the filing of the petition,
has an outstanding swap agreement with the debtor”. (11 USC 101§(53C))
Financial participants are entities with forward contracts, swap agreements or
master netting agreements for a gross dollar value of $1 billion or more in
notional or actual principal outstanding on any day in the previous 15 months or
gross mark to market positions of $100 million or more in one or more such
agreement or transaction on any day in the previous 15 months. (11 USC
§101(22A))
The safe harbor exemption allows the enforcement of contractual rights to
terminate, liquidate, and/or setoff obligations
This allows the creditor to avoid market risk on these obligations
Creates a right almost equivalent to a secured claim to the extent of the setoff
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II. Treatment in Bankruptcy
B. Safe Harbor Rights
2. Safe harbor rights exist to reduce market
disruption when a participant goes bankrupt
3. Safe harbor rights must be created in a contract
to be enforced
4. Safe harbor rights protect setoff timing
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II. Treatment in Bankruptcy
C. Setoff in the Bankruptcy Code - §553(a)
1. Equitable right in the discretion of the Court
2. In order to setoff:
a. Obligations setoff must have arisen prior to the
bankruptcy proceeding
b. Obligations setoff must be enforceable
c. Obligations must be owed in the same capacity
3. Does not create a right of setoff but bars
interference with these rights
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II. Treatment in Bankruptcy
D. Setoff of Collateral
1. Bankruptcy Code §362(b) exempts from the
automatic stay:
a. The setoff of settlement payments arising out of
forward contracts against collateral
b. The setoff of mutual debts under a swap agreement
against collateral
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III.
Treatment in Energy
Commodity Contracts
A. NAESB
1. Natural Gas
2. Netting
•
Parties can elect netting of monthly obligations
3. Setoff
•
•
Following early termination
Can elect whether setoff will apply to all agreements
or only the NAESB
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III.
Treatment in Energy
Commodity Contracts
B. ISDA
1. Derivatives
2. Netting
•
Can elect netting to apply
3. Setoff
•
•
•
1992 version does not contain setoff
Parties usually add in the schedule
2002 version includes a setoff provision applying to
all amounts owed between the parties
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IV. Treatment in Joint
Operating Agreement
A. 1977 and 1982 Model Form Operating
Agreements
•
•
“[U]pon default by any Non-Operator in the
payment of its share of expense, Operator shall
have the right, without prejudice to other rights
or remedies, to collect from the purchaser the
proceeds from the sale of such Non-Operator’s
share of oil and or gas until the amount owed by
such Non-Operator, plus interest has been paid.”
This is the exercise of a lien and security interest
rather than a netting or setoff.
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IV. Treatment in Joint
Operating Agreement
A. 1989 Model Form Operating Agreement
•
•
“[U]pon default by any Non-Operator in the payment of
its share of expenses, interests or fees, or upon the
improper use of funds by the Operator, the other
parties shall have the right, without prejudice to other
rights or remedies, to collect from the purchaser the
proceeds from the sale of such defaulting party’s share
of Oil and Gas until the amount owed by such party,
plus interest as provided in “Exhibit C,” has been
received, and shall have the right to offset the amount
owed against the proceeds from the sale of such
defaulting party’s share of Oil and Gas.”
This version provides and explicit, albeit limited, right of
setoff.
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IV. Treatment in Joint
Operating Agreement
B. Setoff
•
•
Not referred to specifically in 1977 or 1982
Model Form Operating Agreement
1989 Model Form Operating Agreement Article
VII contains a setoff provision
•
If a party defaults in paying expenses, or the operator
improperly uses funds, the other parties may setoff the
amount owed against the proceeds from the sale of the
defaulting party’s oil and gas
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Conclusion
•
•
•
Netting, recoupment, and setoff are valuable, each
to achieve different goals
Recoupment and setoff are especially valuable in
bankruptcy
Netting, recoupment, and setoff may exist as
procedural or common law rights, but it is advisable
to include them in your contracts and to tailor the
provisions to suit your needs
34