ENERGY FINANCE & CREDIT SUMMIT 2004
description
Transcript of ENERGY FINANCE & CREDIT SUMMIT 2004
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;
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
Don’t Terminate
Event of Default
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Mechanics of Early Termination & Liquidation Provisions
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold CollateralEvent of
Default
Mechanics of Early Termination & Liquidation Provisions
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold CollateralEvent of
Default
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
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
Mechanics of Early Termination & Liquidation Provisions
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
Mechanics of Early Termination & Liquidation Provisions
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
Delivery
Return
Mechanics of Early Termination and Liquidation Provisions
Don’t Terminate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
Ipso Facto Considerations
Terminate and
Liquidate
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 caseThe 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
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
The Early Termination and Liquidation Process Example
Party A Party B
MMBtu$50,000MMBtu$25,000
Party B: Files for bankruptcy
Party A: Terminates transactions
Liquidates transactions
Sets off $25,000.00 against $50,000.00
Result: 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
Don’t Terminate
Terminate and
Liquidate
Notice and Designation
of Early Termination
DateTerminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
Automatic Early Termination
Mechanics of Early Termination & Liquidation Provisions
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold CollateralEvent of
Default
All Transactions
Cherry Pick
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
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
Terminate
Liquidation
Liquidation is the process by which the value of the terminated transactions is realized by the non-defaulting party.
Liquidation
Date of LiquidationCalculating 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
Mechanics of Early Termination & Liquidation Provisions
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
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
Setoff – Single Agreement
Party A Party B
$50,000MMBtu
$25,000
Party B: Files for bankruptcy
Party A: Terminates transactions
Liquidates transactions
Sets off $25,000.00 against $50,000.00
Result: 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 Party B
Derivatives$10,000MMBtu
$50,000
Party B: Files for bankruptcy
Party A: Terminates transactions
Liquidates transactions
Sets off $35,000.00 against $50,000.00
Result: Party A pays Party B $15,000.00 instead of $50,000.00
Party B pays $-0- instead of $35,000.00
$25,000
Setoff – Triangular Cross-AffiliateDerivatives
MMBtu$50,000
$25,000
Party B: Files for bankruptcy
Party A:Terminates transactions
Liquidates transactions
Sets off $90,000.00 against $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
Party A Party B
Party B
Affiliate
$55,000
Derivatives$40,000
Party B and Party B Affiliate owe to Party A
Party A owes to Party B and Party B Affiliate
MMBtu $50,000.00Derivatives $40,000.00
$90,000.00
MMBtu $25,000.00Derivatives $55,000.00
$80,000.00
Setoff – Rectangular Cross-AffiliateOil
MMBtu$50,000
$25,000
•Party B: Files for bankruptcy
•Party A:Terminates transactions
•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
Party A Party B
Party B
Affiliate
$55,000
Derivatives$40,000
Party B and Party B Affiliate owe to Party A and Party A Affiliate
Party A and Party A Affiliate owe to Party B and Party B Affiliate
MMBtu $50,000.00Derivatives $45,000.00
$95,000.00
MMBtu $25,000.00
Oil $62,000.00$87,000.00
Party A Affiliate Derivatives
$5,000
Oil $7,000
Mechanics of Early Termination & Liquidation Provisions
Don’t Terminate
Terminate and
Liquidate
Notice and Designation of
Early Termination
Date
Terminate Liquidation Setoff Payment
Do Nothing
Suspend Payment
Suspend Performance
Withhold Collateral
Event of Default
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
Regulatory Risk
NRG bankruptcy In battle of bankruptcy court and FERC, who
possesses superior authority?
State political consideration