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TULA 2003 CONFERENCE. Hyatt Regency Chesapeake Bay Cambridge, Maryland October 1-3, 2003. Getting by with a little help from your friends . An analysis of the EEI and NAESB Master Agreements and how they can help you . Steve Van Hooser Duke Field Services

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tula 2003 conference

TULA 2003CONFERENCE

Hyatt Regency Chesapeake Bay

Cambridge, Maryland

October 1-3, 2003

slide2

Getting by with a little help from your friends

An analysis of the EEI and NAESB Master Agreements and how they can help you

Steve Van Hooser Duke Field Services

Craig Enochs Jackson Walker L.L.P.

slide3

Topics of Discussion

  • What are the EEI and NAESB?
  • What are the benefits of using the EEI and NAESB?
  • Why were they drafted?
  • Architecture of the agreements
  • What are the weaknesses of the EEI and NAESB?
  • Issues to consider when entering into an EEI or NAESB
  • Common special provisions
  • Mano a mano
slide4

I. What are the EEI and NAESB?

  • EEI
    • • A master purchase and sale agreement for wholesale electricity transactions
    • • Also used by some parties for, but not drafted specifically for use with, emissions, capacity and retail transactions
    • • Promulgated by the Edison Electric Institute, and available free on the EEI website (www.eei.org)
slide5

Cont. I. What are the EEI and NAESB?

B. NAESB

•A master purchase and sale agreement for natural gas transactions

• Promulgated by the North American Energy Standards Board

Website: (www.naesb.org)

• Various NAESB forms are available for a fee on the NAESB website

slide6

II. What are the benefits of the EEI and NAESB?

  • Master Contracts
  • 1. Decrease the time and expense of negotiations.
  • 2. Increase standardization across contracts and across the industry.
  • 3. Create consistent terms across transactions for the same product with the same counterparty.
  • 4. Rapid execution of transactions once master is in place.
  • 5. Provide for credit support on a net basis across multiple transactions under the same master agreement.
  • a. This aggregation of credit allows the use of collateral that would be impractical if credit were provided for each transaction individually (e.g. l/c’s; guaranties)
slide7

Cont. II. What are the benefits of the EEI and NAESB?

B. Modularity

  • Can elect to use credit provisions, add credit annexes, or omit credit
  • Suitable for use across different types of counterparties
  • a. Merchant – merchant
  • b. Producer/Generator – merchant
  • c. Merchant – end–user
  • d. Public sector – private sector
  • e. Regulated – unregulated
slide8

Cont. II. What are the benefits of the EEI and NAESB?

C. Enforceability

  • Provisions vetted across the industry
  • Even if disputes arise, can fall back on the strength of industry practice
slide9

III. Why were the EEI and NAESB drafted?

A. EEI

  • Developed during the heyday of energy trading and released in 2000.
  • Before the EEI, every transaction involved a proprietary agreement that was usually, but not always, a master agreement.
  • The EEI sought to provide a standardized master agreement for the power industry like the ISDA and GISB .
  • EEI wanted an agreement that would be widely used and that was fair to all market participants.
    • a. it involved large trading companies (e.g., Enron, Reliant, Duke), large E&P companies with small power interests (e.g. BP), merchant power generators (e.g. Calpine), regulated utilities (e.g. PG&E) and quasi-governmental entities (e.g. Bonneville Power Administration, Salt River Project) in the drafting process.
    • b. Noticeably excluded Canadian input
slide10

Cont. III. Why were the EEI and NAESB drafted?

  • Whether it achieved its goal of fair representation is debatable, as certain sectors view its provisions as flawed in significant ways
  • a. E.g., regulated entities typically feel Schedule M, designed to address the unique circumstances of regulated entities, is profoundly flawed and in some areas ignores the laws governing these entities
  • b. While the EEI cannot be all things to all people, it is the best standardized document in existence for physical power transactions.
slide11

Cont. III. Why were the EEI and NAESB drafted?

B. NAESB

1. Created by NAESB, the North American Energy Standards Board (f/k/a the Gas Industry Standards Board, or “GISB”)

2. NAESB states that is an industry forum that works to develop and promote standards that will lead to a seamless wholesale and retail market place.

3. Drafted in 2002, it is the gas equivalent of the EEI.

4. Sought to continue the success of the GISB Master Agreement.

slide12

Cont. III. Why were the EEI and NAESB drafted?

  • The GISB Master Gas Purchase and Sale Agreement preceded the NAESB and became nearly ubiquitous.
  • The GISB had some notable deficiencies in credit and in its close-out provisions.
  • The NAESB sought to preserve the successful elements of the GISB while improving on its weaknesses.
  • The GISB was drafted before the energy trading boom, and NAESB wanted to address some of these ensuing changes in the industry.
  • The GISB was being used in ways other than it was originally intended, such as for long-term transactions, and NAESB wanted an agreement better suited for these deals.
slide13

Architecture of the EEI and NAESB

A. EEI

1. EEI begins with Master Agreement and Cover Sheet

a. Cover Sheet is a check-the-box and fill- in-the-blank format

b. Included in Master Agreement are Schedules M and P

1. Schedule M contains provisions for regulated entities, Schedule P contains descriptions of the products.

slide14

Cont. IV. Architecture of the EEI and NAESB

  • No other document is required to transact.
  • Parties usually customize by adding special provisions.
  • EEI has introduced a Collateral Annex with more sophisticated and more detailed credit options.
    • Although the Collateral Annex has some deficiencies, it is widely used.
    • Counterintuitively, although it is an additional document, the use of the Collateral Annex often saves time because it reduces the number of credit terms the parties negotiate and most of the terms are relatively uncontroversial among market participants
      • 1. Typically, fewer special provisions are added to the Collateral Annex than to the Master Agreement.
slide15

Cont. IV. Architecture of the EEI and NAESB

  • NAESB
  • 1. Also begins with Cover Sheet and Master Agreement
  • a. Cover Sheet is shorter than the EEI Cover Sheet because it offers fewer options.
  • (1.) NAESB Cover Sheet does not address credit issues
  • 2. Parties often modify with special provisions.
  • 3. The NAESB Master Agreement does not address credit issues other than to include an adequate assurances provision.
slide16

Cont. IV. Architecture of the EEI and NAESB

C. Common Elements in both the EEI and NAESB.

  • Term
  • Confirmation
  • Liquidated Damages
  • Force Majeure
  • Events of Default
  • Early Termination and Liquidation
  • Billing
  • Credit
slide17

Weaknesses of the EEI and NAESB

  • EEI
    • Goldilocks syndrome
    • a. Too short for some (GISB), too long for others (ISDA).
    • b. Too few products (capacity, emissions), too many products (Schedule M, Schedule P).
  • NAESB
  • 1. Weak credit treatment.
  • C. Neither is designed for use in Canada
slide18

Issues to Consider

  • Liquidated damages
  • 1. Cover v. index price optionality
  • Products
    • Do you use non-EEI products specific to an individual ISO or RTO?
      • Ex. PJM West, CAISO
  • Events of Default
  • 1. Do you expand on the list in the agreement?
  • a. ISDA, EEI and NAESB all handle events of default differently
  • b. Ex. Cross default
  • 1. Cross-product?
  • 2. Cross-affiliate?
  • 3. Limit to indebtedness (ISDA) or include any amount owed (EEI)?
slide19

Cont. VI. Issues to Consider

D. Credit

  • Elections in Cover Sheet / Collateral Annex
  • Single-agreement or cross-agreement margining?
  • Fallback under UCC §2-609?
    • Is power a good under the UCC?
      • (1.) Gas is a good under the UCC
    • Are non-contractual remedies disclaimed in these masters?
    • (1.) Both the EEI and NAESB in their standard form bar non-contractual remedies.
  • Acceptable forms of collateral
slide20

Cont. VI. Issues to Consider

  • Fixed threshold v. credit matrix
  • 6. What happens if a party suffers a credit rating downgrade?
    • Custodian
    • Return collateral
  • 7. What happens if a party suffers an event of default?
    • Custodian
    • Return collateral
  • 8. Security interest in accounts receivable
    • Why is this important?
    • 1. Without this, run risk of not being permitted to setoff accounts receivable across agreements.
    • b. Problem-Impact of Security Interest Grant on Loan Covenants
slide21

Cont. VI. Issues to Consider

E. Early Termination and Liquidation

1. What is early termination and liquidation?

a. 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 marked-to-market value as of the date of early termination.

b. Early termination and liquidation is triggered by events of default.

slide22

Cont. VI. Issues to Consider

2. What is a Forward Contract?

  • a. ''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;
2 what is a forward contract
2. What is a Forward Contract?

Cont. VI. Issues to Consider

b. As a general rule, commodity transactions for delivery more than two days in the future are Forward Contracts.

3 events of default

Cont. VI. Issues to Consider

3. Events of Default

a. Events of default are contractual breaches that trigger the right to terminate and liquidate the agreement.

b. They are occurrences that are sufficiently serious to give rise to the remedy of early termination and liquidation.

c. They are generally objective

d. Example

1. Failure to pay

2. Failure to deliver collateral-or perform other material covenant

3. Bankruptcy

4. Cross-default on third-party debt

e. New types

1. Cross-default under any obligation

2. Default under any agreement between the parties

3. Default under any agreement between the parties’ affiliates

4. Diminution of guarantor’s ownership share in guaranteed party

4 what are the benefits of early termination and liquidation provisions

Cont. VI. Issues to Consider

4. What are the benefits of early termination and liquidation provisions?

a. 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.

b. Reduce credit exposure to the counterparty.

c. Preserve the value of the terminated transactions.

d. Provide the ability to resolve claims with a bankrupt party outside of the bankruptcy proceeding.

e. Permit setoff of obligations.

f. Provide certainty of exposure for risk determination.

g. Provide an independent and precise structure to terminate and liquidate transactions without having to resort to litigation.

5 mechanics of early termination liquidation provisions
5. 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

5 mechanics of early termination liquidation provisions27
5. 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

5 mechanics of early termination liquidation provisions28
5. 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

Terminate

Liquidation

Payment

Setoff

why would a party choose to take no action
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
5 mechanics of early termination liquidation provisions30
5. 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

5 mechanics of early termination liquidation provisions31
5. 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

5 mechanics of early termination liquidation provisions32
5. Mechanics of Early Termination & Liquidation Provisions

Do Nothing

Suspend Payment

Don’t Terminate

Suspend Performance

Delivery

Event of Default

Withhold Collateral

Return

Notice and Designation of Early Termination Date

Terminate and Liquidate

Liquidation

Payment

Terminate

Setoff

5 mechanics of early termination and liquidation provisions
5. Mechanics of Early Termination and Liquidation Provisions

Do Nothing

Suspend Payment

Don’t Terminate

Ipso Facto Considerations

Suspend Performance

Event of Default

Withhold Collateral

Notice and Designation of Early Termination Date

Terminate and Liquidate

Liquidation

Payment

Setoff

Terminate

mechanics of early termination and liquidation provisions
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
ipso facto provisions
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.

• This can create exposure if you were counting on setting off the obligations under the two agreements.

5 mechanics of early termination liquidation provisions36
5. 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

the early termination and liquidation process example
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

5 mechanics of early termination liquidation provisions38
5. 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

Terminate

Liquidation

Payment

Setoff

Automatic Early Termination

5 mechanics of early termination liquidation provisions39
5. 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

cherry picking
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
5 mechanics of early termination liquidation provisions41
5. 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

Terminate

Payment

Setoff

liquidation
Liquidation
  • Date of Liquidation
  • Calculating Party
  • Valuation Method
  • Net Present Value
liquidation43
Liquidation
  • Date of Liquidation
  • Calculating Party
    • Non-defaulting Party
    • Third-party
  • Valuation Method
  • Net Present Value
liquidation44
Liquidation
  • Date of Liquidation
  • Calculating Party
  • Valuation Method
    • Market Quotation
      • NAESB’s sole method
    • Loss
  • Net Present Value
liquidation45
Liquidation
  • Date of Liquidation
  • Calculating Party
  • Valuation Method
    • Market Quotation
    • Loss
  • Net Present Value
liquidation46
Liquidation
  • Date of Liquidation
  • Calculating Party
  • Valuation Method
  • Net Present Value
5 mechanics of early termination liquidation provisions47
5. 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

setoff
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
Types of Setoff
  • Single Agreement
  • Cross-Product
  • Cross-Affiliate
setoff single agreement
Setoff – Single Agreement

Party A

$50,000

Party B

MMBtu

$25,000

Power

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
Setoff – Cross-Product

Power

Party A

Party B

$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

setoff triangular cross affiliate
Setoff – Triangular Cross-Affiliate

Power

Party B

Party A

$55,000

MMBtu

$50,000

$25,000

Power$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

Power

$55,000.00

Power

$40,000.00

$80,000.00

$90,000.00

setoff rectangular cross affiliate
Setoff – Rectangular Cross-Affiliate

Derivatives

Party A

$55,000

Party B

MMBtu

$50,000

$25,000

Derivatives $7,000

Party B

Affiliate

Party A

Power $5,000

Power$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

Derivatives

Power

$45,000.00

$87,000.00

$95,000.00

5 mechanics of early termination liquidation provisions54
5. 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

payment
Payment
  • One-way
  • Two-way
  • Interest
payment56
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
payment57
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
payment58
Payment
  • One-way
  • Two-way
  • Interest
6 regulatory risk
6. Regulatory Risk

a. NRG bankruptcy

1. In battle of bankruptcy court and FERC, who possesses superior authority?

2. Mirant bankruptcy

b. State political consideration

c. Waiting for congressional or judicial clarification

slide60

VII. Common Special Provisions

  • Cross-default
    • Requiring acceleration rather than default for a cross-default to occur
    • Expanding cross-default to other agreements between the parties
    • Expanding cross-default to other agreements between the parties’ affiliates
slide61

Cont. VII. Common Special Provisions

  • Early Termination and Liquidation
    • Permitting the Non-Defaulting Party to delay payment to the Defaulting Party until it ascertains the Defaulting Party has satisfied all payment obligations it owes to the Non-Defaulting Party
    • Permitting the Non-Defaulting Party to delay liquidating transactions that are illegal or impractical to liquidate
  • New Taxes
    • Permitting early termination and liquidation of the affected transactions
    • Providing in advance for the allocation of any new tax burden
slide62

Cont. VII. Common Special Provisions

  • Index Transactions
    • 1. Providing for alternate means of valuation if the index providing the price for a transaction for some reason fails to publish such price
  • Additional Products
    • Adding products customary for a single region
    • Adding provisions relating to options
slide63

Cont. VII. Common Special Provisions

  • Alternative Dispute Resolution
    • Mandatory meeting of senior executives and mediation
    • Binding arbitration
  • Mobile-Sierra Doctrine
  • Confidential Tax Provisions