Early Termination and Liquidation Provisions in Energy Trading and ...

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Table of ContentsI. Master Agreements in General..............................................................................................................1A. Remedies found in master agreements.............................................................................................1B. Liquidated damages compared to early termination and liquidation rights........................................1II. Summary of Early Termination and Liquidation Clauses .....................................................................2A. History of clauses in relation to master agreements .........................................................................2B. Events of default .............................................................................................................................2C. Termination events..........................................................................................................................2D. Summary of the early termination and liquidation remedy...............................................................2E. Summary of liquidation...................................................................................................................3F. Summary of setoff...........................................................................................................................3III. Mechanics of Procedure.....................................................................................................................3A. Events of default.............................................................................................................................31. New events of default..............................................................................................................3B. Notice of an event of default and early termination date ..................................................................5C. Election of remedy..........................................................................................................................51. Cherry-picking transactions to terminate .................................................................................52. Non-exclusive nature ..............................................................................................................5D. Liquidation .....................................................................................................................................61. Market quotation versus loss ...................................................................................................62. Net present value ....................................................................................................................73. Disputed valuations.................................................................................................................74. One-way versus two-way payment ..........................................................................................7E. Setoff ..............................................................................................................................................81. In general................................................................................................................................82. Cross-product setoff................................................................................................................83. Cross-party setoff....................................................................................................................94. Setoff of collateral ..................................................................................................................9IV. Bankruptcy ........................................................................................................................................9A. In general........................................................................................................................................9B. Automatic stay..............................................................................................................................101. Exemptions from the automatic stay......................................................................................10a. Forward contracts and swap agreements defined ...............................................................10b. Importance of exemptions from the automatic stay............................................................11C. Avoidance action claims ...............................................................................................................111. Preferences and fraudulent transfers ......................................................................................12a. Types of fraudulent transfers.............................................................................................12b. In re Olympic Natural Gas Company ................................................................................12c. Avoidance actions and swap agreements ...........................................................................12D. Ipso facto provisions.....................................................................................................................13V. Conclusion........................................................................................................................................13i
I. Master Agreements in GeneralThe term “master agreement” generally means an agreement, often standardized for a commodity, with termsand conditions that will apply to multiple transactions, each evidenced by a brief transaction confirmation.Master agreements can be used for physically-delivered commodities or over-the-counter derivativetransactions. 1 Standardized master agreements are commonly used to manage the risks associated withenergy trading and marketing transactions. Recent history demonstrates that such risks are numerous andsubstantial and can be costly if left unmitigated. Several events, including Enron’s bankruptcy, 2 the recentand ongoing credit rating downgrades of some of the industry’s largest energy trading companies, and thesubsequent exit from the industry of some of those companies, 3 have dramatically changed the way manyenergy trading and marketing companies view, measure and mitigate credit risk. This change in perspectiveis causing companies to re-examine master agreements to take advantage of some of the hard lessons learnedin the months following Enron’s bankruptcy filing. In addition, non-traditional participants are entering themarket and bringing with them new ideas concerning credit and risk management. Although parties apply itin different ways, the most common type of contractual provision used to manage credit risk in masteragreements is the early termination and liquidation provision. This paper analyzes the contents, mechanicsand implications of early termination and liquidation provisions commonly used in master agreements.A. Remedies found in master agreementsMaster agreements typically contain two types of remedies for the breaching party’s nonperformance:liquidated damages and early termination and liquidation. Upon a party’s breach of its obligation to deliver orreceive a commodity under a master agreement, the non-breaching party is usually entitled to recoverliquidated damages. 4 Liquidated damages can be calculated using the cover standard, which provides for therecovery of the difference between the contract price and the market price to purchase substitute quantities ofthe commodity, 5 or the spot standard, which is calculated by subtracting the contract price from either themarket price quoted by independent market participants or a published, index price. 6 While these liquidateddamages typically include incremental costs incurred as a result of the breach and the subsequent coveringprocess, such as imbalance penalties or additional transmission costs, 7 they exclude other costs, such asadministrative costs incurred in replacing the transaction. 8 Upon an event of default, termination andliquidation provisions define the non-defaulting party’s rights under the master agreement. Events of defaultare carefully defined in master agreements but usually include any significant breach other than those relatedto the failure to deliver or receive a physical commodity.B. Liquidated damages compared to early termination and liquidation rightsLiquidated damages and early termination and liquidation differ in several material respects. Liquidateddamages are usually the non-defaulting party’s sole and exclusive remedy for the other party’s failure toperform its obligations to deliver or receive the energy commodity under a master agreement between theparties. As a result, the payment by the defaulting party of the liquidated damages prevents an event ofdefault under the agreement and the affected transactions and the master agreement continues in full force andeffect. Industry participants typically treat liquidated damages as a routine occurrence and envision thecontinuation of the master agreement and the transaction despite the failure that caused the liquidateddamages.In contrast, early termination and liquidation rights arise when there has been an occurrence, other than afailure to deliver or receive a commodity, that has global implications upon performance under the masteragreement and/or the financial obligations of the parties. These occurrences typically relate to the credit,payment history, and/or solvency of the defaulting party. The broad scope of events of default can cause theiroccurrence under one agreement to create early termination and liquidation rights under another agreement.Likewise, a failure on the part of or action of a guarantor or affiliate of a party to a master agreement can alsoconstitute an event of default. Upon an event of default, early termination and liquidation provisions usuallyprovide a number of rights to the non-defaulting party, including: (i) the right to terminate all outstandingtransactions under a master agreement; (ii) the right to liquidate the terminated transactions; (iii) the right to1
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Page 5 and 6: It may seem counterintuitive that a
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