NETTING AND OFFSET PRINCIPLES IN ENERGY TRANSACTIONS

CRAIG R. ENOCHS Jackson Walker L.L.P.

1401 McKinney, Suite 1900Houston, Texas 77010

State Bar of Texas24th Annual Advanced Oil Gas &

Energy Resources Law CourseOctober 5-6, 2006Houston, Texas

Chapter 9

2

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. Netting1. 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. Netting5. 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. Setoff1. 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. Setoff6. 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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Party A Party B$50,000

$25,000

Party B: Files for bankruptcy

Party A: Terminates transactionsLiquidates transactions

Result:

With Single Agreement Setoff Party A pays $25,000 Party B pays $-0-

Without Setoff Party A pays $50,000Party B pays $25,000 in bankruptcy dollars

I. Netting, Setoff, and Recoupment

B. Setoff 1.Single Agreement

MMBtu

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Party A Party B

Power$10,000

MMBtu$50,000

Party B: Files for bankruptcy

Party A: Terminates transactions Liquidates transactions

$25,000

I. Netting, Setoff, and Recoupment B. Setoff 2. Cross-Product

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Party A Party B

Power$10,000MMBtu$50,000

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

$25,000

I. Netting, Setoff, and Recoupment B. Setoff 2. Cross-Product

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Power

MMBtu$50,000

$25,000

Party B and Party B Affiliatefile for bankruptcy

Party A:Terminates transactions

Liquidates transactions

Party A Party B

Party B

Affiliate

$55,000

Power$40,000

Party B and Party B Affiliate owe to Party A

Party A owes to Party B and Party B Affiliate

MMBtu $50,000.00

Power $40,000.00

$90,000.00

MMBtu $25,000.00Power $55,000.00

$80,000.00

I. Netting, Setoff, and Recoupment B. Setoff 3. Triangular Cross-Affiliate/Cross-Product

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Power

MMBtu$50,000$25,000

Result:

With Triangular Cross-Affiliate/Cross-Product Setoff

Party A Party B

Party B

Affiliate

$55,000

Power$40,000

I. Netting, Setoff, and Recoupment B. Setoff 3. Triangular Cross-Affiliate/Cross-Product

Party A pays Party B and Party B Affiliate $10,000

Party B and Party B Affiliate pay Party A $-0-

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Power

MMBtu$50,000

$25,000

With Cross-Product Setoff Party A pays Party B $-0- Party A pays Party B Affiliate $40,000Party 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

Party A Party B

Party B

Affiliate

$55,000

Power$40,000

I. Netting, Setoff, and Recoupment B. Setoff 3. Triangular Cross-Affiliate/Cross-Product

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Derivatives

MMBtu$50,000$25,000

•Party B: Files for bankruptcy

•Party A: - Terminates transactions

- Liquidates transactions

Party A Party B

Party B

Affiliate

$55,000

Power$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 $50,000.00

Power $45,000.00

$95,000.00

MMBtu $25,000.00Derivatives $62,000.00

$87,000.00

Party A

AffiliatePower $5,000

Derivatives $7,000

I. Netting, Setoff, and RecoupmentB. Setoff 4. Rectangular Cross-Affiliate/Cross-Product

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Derivatives

MMBtu$50,000$25,000

Party A Party B

Party B

Affiliate

$55,000

Power$40,000

Party A

AffiliatePower $5,000

Derivatives $7,000

I. Netting, Setoff, and RecoupmentB. Setoff 4. Rectangular Cross-Affiliate/Cross-Product

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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Derivatives

MMBtu$50,000$25,000

Party A Party B

Party B

Affiliate

$55,000

Power$40,000

Party A

AffiliatePower $5,000

Derivatives $7,000

I. Netting, Setoff, and RecoupmentB. Setoff 4. Rectangular Cross-Affiliate/Cross-Product

Result:

With Triangular Cross-Affiliate/Cross-Product Setoff

Party A and Party A Affiliate pay Party B $-0-

Party 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 $-0-

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Derivatives

MMBtu$50,000$25,000

Party A Party B

Party B

Affiliate

$55,000

Power$40,000

Party A

AffiliatePower $5,000

Derivatives $7,000

I. Netting, Setoff, and RecoupmentB. Setoff 4. Rectangular Cross-Affiliate/Cross-Product

Result:

With Cross-Product Setoff Party A pays Party B $-0-Party A Affiliate pays Party B $5,000 Party B pays Party A $30,000 in bankruptcy dollarsParty A pays Party B Affiliate $40,000 Party B Affiliate pays Party A Affiliate $7,000 in bankruptcy dollars

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Derivatives

MMBtu$50,000$25,000

Party A Party B

Party B

Affiliate

$55,000

Power$40,000

Party A

AffiliatePower $5,000

Derivatives $7,000

I. Netting, Setoff, and RecoupmentB. Setoff 4. Rectangular Cross-Affiliate/Cross-Product

Result:

With Single Agreement Setoff Party A pays Party B $25,000Party B pays Party A $55,000 in bankruptcy dollarsParty A pays Party B Affiliate $40,000Party A Affiliate pays Party B $5,000 Party B Affiliate pays Party A Affiliate $7,000 in bankruptcy dollars

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Derivatives

MMBtu$50,000$25,000

Party A Party B

Party B

Affiliate

$55,000

Power$40,000

Party A

AffiliatePower $5,000

Derivatives $7,000

I. Netting, Setoff, and RecoupmentB. Setoff 4. Rectangular Cross-Affiliate/Cross-Product

Result:

Without Setoff Party A pays Party B $50,000Party B pays Party A $80,000 in bankruptcy dollarsParty A pays Party B Affiliate $40,000Party 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. Recoupment1. 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. Recoupment3. 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 Stay1. 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 Rights1. 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 BankruptcyB. 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 Rights2. 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. NAESB1. 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. ISDA1. 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