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ENERGY FINANCE & CREDIT SUMMIT 2004

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

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ENERGY FINANCE & CREDIT SUMMIT 2004

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

  2. 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

  3. 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.

  4. 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?

  5. 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.

  6. 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;

  7. What is a forward contract? • As a general rule, gas transactions for delivery more than two days in the future are forward contracts.

  8. 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;

  9. What is a swap agreement? • In general, derivative hedge agreements are swap agreements.

  10. 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

  11. 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.

  12. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Withhold Collateral Event of Default Notice and Designation of Early Termination Date Terminate and Liquidate Liquidation Payment Setoff Terminate

  13. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Withhold Collateral Event of Default Notice and Designation of Early Termination Date Terminate and Liquidate Liquidation Payment Setoff Terminate

  14. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Withhold Collateral Event of Default Notice and Designation of Early Termination Date Terminate and Liquidate Liquidation Payment Setoff Terminate

  15. 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

  16. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Liquidation Payment Setoff Terminate

  17. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Liquidation Payment Setoff Terminate

  18. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Delivery Event of Default Withhold Collateral Return Terminate and Liquidate Notice and Designation of Early Termination Date Liquidation Payment Setoff Terminate

  19. Mechanics of Early Termination and Liquidation Provisions Do Nothing Suspend Payment Ipso Facto Considerations Don’t Terminate Suspend Performance Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Liquidation Payment Setoff Terminate

  20. 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 case • The appointment of a trustee or custodian

  21. 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.

  22. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Notice and Designation of Early Termination Date Terminate and Liquidate Liquidation Payment Setoff Terminate

  23. The Early Termination and Liquidation Process Example MMBtu Party A Party B $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

  24. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Notice and Designation of Early Termination Date Terminate and Liquidate Liquidation Payment Setoff Terminate Automatic Early Termination

  25. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Withhold Collateral Event of Default All Transactions Notice and Designation of Early Termination Date Terminate and Liquidate Liquidation Payment Setoff Terminate Cherry Pick

  26. 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

  27. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Terminate and Liquidate Notice and Designation of Early Termination Date Liquidation Payment Setoff Terminate

  28. Liquidation Liquidation is the process by which the value of the terminated transactions is realized by the non-defaulting party.

  29. Liquidation • Date of Liquidation • Calculating Party • Valuation Method • Net Present Value

  30. Liquidation • Date of Liquidation • Calculating Party • Non-defaulting Party • Third-party • Valuation Method • Net Present Value

  31. Liquidation • Date of Liquidation • Calculating Party • Valuation Method • Market Quotation • Loss • Net Present Value

  32. Liquidation • Date of Liquidation • Calculating Party • Valuation Method • Market Quotation • Loss • Net Present Value

  33. Liquidation • Date of Liquidation • Calculating Party • Valuation Method • Net Present Value

  34. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Notice and Designation of Early Termination Date Terminate and Liquidate Liquidation Payment Setoff Terminate

  35. 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

  36. Types of Setoff • Single Agreement • Cross-Product • Cross-Affiliate

  37. Setoff – Single Agreement $50,000 Party B Party A 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 $-0- instead of $25,000.00

  38. Setoff – Cross-Product Derivatives Party B Party A $10,000 MMBtu $50,000 $25,000 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

  39. Setoff – Triangular Cross-Affiliate Derivatives Party B $55,000 Party A MMBtu $50,000 $25,000 Derivatives$40,000 Party B Affiliate 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 B and Party B Affiliate owe to Party A Party A owes to Party B and Party B Affiliate $25,000.00 MMBtu MMBtu $50,000.00 Derivatives $55,000.00 Derivatives $40,000.00 $80,000.00 $90,000.00

  40. Setoff – Rectangular Cross-Affiliate Oil Party B $55,000 Party A MMBtu $50,000 $25,000 Oil $7,000 Party B Affiliate Party A Derivatives $5,000 Derivatives$40,000 Affiliate 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 • 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 MMBtu $25,000.00 MMBtu $50,000.00 $62,000.00 Oil Derivatives $45,000.00 $87,000.00 $95,000.00

  41. Mechanics of Early Termination & Liquidation Provisions Do Nothing Suspend Payment Don’t Terminate Suspend Performance Event of Default Withhold Collateral Notice and Designation of Early Termination Date Terminate and Liquidate Payment Liquidation Setoff Terminate

  42. Payment • One way • Two way • Interest

  43. 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

  44. 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

  45. Payment • One way • Two way • Interest

  46. Regulatory Risk • NRG bankruptcy • In battle of bankruptcy court and FERC, who possesses superior authority? • State political consideration

  47. Conclusion • Early termination and liquidation provisions can be valuable tools • Pitfalls exist • Check with legal advisors

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