ENERGY FINANCE & CREDIT SUMMIT 2004 February 25-27, 2004 Houston, Texas.

ENERGY FINANCE & CREDIT SUMMIT 2004

February 25-27, 2004

Houston, Texas

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

http://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

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


Don’t Terminate

Terminate and

Liquidate


Early Termination

Date


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


Don’t Terminate

Terminate and

Liquidate


Early Termination

Date


Do Nothing

Suspend Payment

Suspend Performance

Withhold Collateral

Event of Default


Don’t Terminate

Terminate and

Liquidate


Early Termination

Date


Do Nothing

Suspend Payment

Suspend Performance

Withhold Collateral

Event of Default

Delivery

Return

Mechanics of Early Termination and Liquidation Provisions

Don’t Terminate


Early Termination

Date


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.


Don’t Terminate

Terminate and

Liquidate


Early Termination

Date


Do Nothing

Suspend Payment

Suspend Performance

Withhold Collateral

Event of Default

The Early Termination and Liquidation Process Example

Party A Party B

MMBtu$50,000

MMBtu$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


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


Don’t Terminate

Terminate and

Liquidate


Early Termination

Date


Do Nothing

Suspend Payment

Suspend Performance

Withhold Collateral

Event 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


Don’t Terminate

Terminate and

Liquidate


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 Liquidation Calculating Party Valuation Method Net Present Value

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 Net Present Value


Don’t Terminate

Terminate and

Liquidate


Early Termination

Date


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

Types of Setoff

Single Agreement Cross-ProductCross-Affiliate

Setoff – Single Agreement

Party A Party B

$50,000

MMBtu$25,000




Sets off $25,000.00 against $50,000.00


Party B pays $-0- instead of $25,000.00

Setoff – Cross-Product

Party A Party B

Derivatives

$10,000MMBtu

$50,000




Sets off $35,000.00 against $50,000.00


Party B pays $-0- instead of $35,000.00

$25,000

Setoff – Triangular Cross-AffiliateDerivatives

MMBtu$50,000

$25,000


Party A:Terminates 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 $25,000.00

Derivatives $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

AffiliateDerivatives

$5,000

Oil $7,000


Don’t Terminate

Terminate and

Liquidate


Early Termination

Date


Do Nothing

Suspend Payment

Suspend Performance

Withhold Collateral

Event of Default

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

ENERGY FINANCE & CREDIT SUMMIT 2004 February 25-27, 2004 Houston, Texas.

Documents

Transcript of ENERGY FINANCE & CREDIT SUMMIT 2004 February 25-27, 2004 Houston, Texas.