7th Annual Gas & Power Institute
September 4-5, 2008
Managing “Gap Risk” Between Standard Form
Trading Agreements
Craig R. Enochs
Craig R. Enochs
cenochs@jw.com
Jackson Walker L.L.P.
1401 McKinney, Suite 1900
Houston, Texas 77010
(713) 752-4200 phone
1
Selected Sources of “Gap Risk”
I.
Issues Common to the NAESB, ISDA, EEI and CTA
A. Notices
B. Events of Default
C. Setoff
II.
Other Agreement Differences:
A.
B.
C.
D.
Termination, Liquidation & Settlement: NAESB, ISDA and EEI
Confirmation Procedures: NAESB, ISDA and CTA
Netting: NAESB and ISDA
Transfer and Assignment: CTA and ISDA
*
2
I. Issues Common to the
NAESB, ISDA, EEI and CTA
A. Notices
B. Events of Default
C. Setoff
3
A. Notices
1. NAESB § 9

Methods: Fax, mutually-accepted electronic means, overnight
courier, first class mail or hand delivery

General Rule: deemed delivered when received on a Business
Day

If no proof of actual receipt, the following presumptions apply:

Fax: deemed delivered when sending party receives fax machine’s
confirmation of successful transmission. If after 5:00 p.m., deemed
received the following Business Day

Overnight Courier or Mail: deemed delivered on following Business
Day after sent, or earlier if confirmed by receiving party

First Class Mail: deemed delivered five (5) Business Days after
mailing
4
A. Notices
2. ISDA Master § 12(a): Gas, Power and Coal Annexes

Writing/Hand Delivery: effective on date delivered

Fax: effective on date received by responsible recipient in
legible form

Proof of receipt is on sending party and cannot be proven through
fax confirmation

Certified or Registered Mail: effective on date delivered (or
delivery is attempted)

Electronic Messaging System: effective on date received

Email (2002 ISDA): effective on date delivered
5
A. Notices
2. ISDA Master § 12(a): Gas, Power and Coal Annexes
(cont.)

If notice (i) not delivered on Local Business Day, or (ii) is
delivered after close of business, notice deemed delivered on
following Local Business Day

Notices relating to Events of Default or Termination Events may
not be sent by electronic messaging system (1992/2002), fax
(1992) or email (2002 ISDA).
6
A. Notices
3. EEI § 10.7
 Fax or Hand Delivery:
 If received during business hours on a Business Day, notice
deemed effective at the close of business on such day
 If received after business hours, deemed effective at close of
business on following Business Day
 Overnight Courier or U.S. Mail:
 Deemed effective on the following Business Day after sent
7
A. Notices
4. CTA § 10.3
 Electronic means, fax or hand delivery:
 If delivered during business hours on a Business Day, notice
deemed received at close of business on such day
 If delivered after business hours, deemed received on close of
business of following Business Day
 Overnight mail or courier:
 Deemed received one (1) Business Day after sent
8
A. Notices
5. Risk Analysis
 Operational Risk:
 Various methods of notice permitted in trading contracts
 Ex: ISDA contemplates electronic means, including email (2002 ISDA),
but EEI does not contemplate electronic means unless otherwise
elected by the parties
 Inconsistent notice provisions across trading agreements
 More likely that manner or method of notice may be insufficient
9
A. Notices
5. Risk Analysis (cont.)
 Credit and Payment Risk:
 Ineffective notice may create credit risk as to a defaulting
counterparty:
 Ex: ISDA does not allow electronic means (1992/2002), fax (1992) or
email (2002) notices with respect to Events of Default or Termination
Events
 If notice is ineffective, Non-Defaulting Party cannot declare an Early
Termination Date
 Parties should consider consistent notice provisions across
trading contracts
*
10
B. Events of Default
1. 2002 v. 2006 NAESB: § 10.2
 2002 and 2006 NAESB: each includes the following Events
of Default:
 Failure to pay
 Bankruptcy
 Default under Credit Support Obligations
 2006 NAESB: adds “Additional Event of Default,” which may
be elected on Cover Sheet
 Indebtedness Cross Default: party or Guarantor defaults on
agreements relating to indebtedness for borrowed money
 Transactional Cross Default: party or Guarantor defaults under a
Specified Transaction.
*
11
B. Events of Default
1. 2002 v. 2006 NAESB: § 10.2 (cont.)
 Risk Analysis:
 Additional Events of Default in 2006 NAESB mitigate credit and
commercial risks by looking to performance of obligations outside
the NAESB
 2006 NAESB closes some “gap risk” by moving the 2002 NAESB
closer to the EEI and ISDA
12
B. Events of Default
2. 1992 v. 2002 ISDA: § 5(a)-(b)
 2002 ISDA modifies cure periods:
 Failure to pay or deliver: § 5(a)(i)
 One (1) Local Business Day instead of three (3) Local Business Days
 Default Under Specified Transaction: § 5(a)(v)(2)
 One (1) Local Business Day instead of three (3) Local Business Days
 Bankruptcy § 5(a)(vii)(1)(B):
 Fifteen (15) days instead of thirty (30) days
 Risk Analysis: shorter cure periods mitigate credit risk
13
B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
 Breach of Agreement: § 5(a)(ii)
 2002 ISDA expands Breach of Agreement:
 Event of Default if a party “disaffirms, disclaims, repudiates or
rejects…or challenges the validity of” the ISDA
 With respect to the 2002 language, the 30-day cure period in § 5(a)(ii)
does not apply
 Risk Analysis: allows swifter action when a counterparty clearly
indicates it will not honor its ISDA obligations
14
B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
 Default Under Specified Transaction: § 5(a)(v)
 2002 ISDA expands on events which constitute a default, including:
 Default under credit support arrangement relating to a Specified
Transaction
 Challenging the validity of a Specified Transaction
 “Specified Transaction” includes “catch-all” clause to capture future
derivatives products not otherwise stated
 Risk Analysis:
 Avoids the risk that certain actions may not properly trigger the
Event of Default
 Avoids the risk that certain derivatives may be inadvertently
excluded from the laundry list of “Specified Transactions”
15
B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
 Cross Default: § 5(a)(vi)
 2002 ISDA: To determine whether a party has exceeded Threshold
Amount, party may look to both (i) principal of accelerated
obligations, and (ii) unpaid amounts
 1992 ISDA: Party cannot combine accelerated obligations and
unpaid amounts to determine Threshold Amount
 Risk Analysis: 2002 ISDA makes Cross Default much more
sensitive and useful in situations where a counterparty commits
multiple defaults, but some defaults are difficult to ascertain
16
B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
 Merger Without Assumption: § 5(a)(viii)
 2002 ISDA expands to include reorganization, reincorporation and
reconstitution
 Risk Analysis: Mitigates credit risk by diminishing the ambiguity
of what corporate action triggers this Event of Default
17
B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
 Credit Support Default: § 5(a)(iii)
 2002 ISDA expands to include circumstances when a security
interest granted under a Credit Support Document fails to be in full
force and effect
 Risk Analysis: Mitigates credit risk by expanding Event of
Default upon failure under either (i) Credit Support Document, or
(ii) security interest granted under such document.
18
B. Events of Default
3. NAESB v. ISDA Gas Annex

Common Events of Default: NAESB § 10.2; ISDA § 5(a)




Failure to pay when due
Breach of credit obligations
Insolvency and bankruptcy-related events
Events of Default in ISDA not found in NAESB:





Breach of Agreement (other than failure to pay)
Misrepresentations
Default under Specified Transaction
 Similar to Transactional Cross Default election in 2006 NAESB
Cross Default
 Similar to Indebtedness Cross Default election in 2006 NAESB
Merger Without Assumption
19
B. Events of Default
3. NAESB v. ISDA Gas Annex (cont.)

Termination Events in ISDA not found in NAESB:





Illegality
Force Majeure Event (2002)
Tax Event and Tax Event Upon Merger
Credit Event Upon Merger
Additional Termination Event
*
20
B. Events of Default
4. EEI v. ISDA Power Annex

Common Events of Default: EEI § 5.1 and ISDA § 5(a):

Failure to pay when due

False or misleading representations

Breach of Agreement (other than failure to pay)

Insolvency and bankruptcy-related events

Breach of credit obligations

Merger without assumption

Cross Default
21
B. Events of Default
4. EEI v. ISDA Power Annex (cont.)

Events of Default and Termination Events in ISDA not found in
EEI:

Default under Specified Transaction

Illegality

Force Majeure Event (2002 ISDA)

Tax Event and Tax Event Upon Merger

Credit Event Upon Merger

Additional Termination Event
22
B. Events of Default
5. CTA v. ISDA Coal Annex
 Common Events of Default: CTA § 8.1; ISDA § 5(a)
 Failure to Pay
 Breach of Agreement (other than failing to pay/deliver)
 CTA: Cure Period of ten (10) Business Days, but potential extension of
up to sixty (60) days
 ISDA: Thirty (30)/Fifteen (15) Business Days (1992/2002)




Credit Support Default
Misrepresentation
Cross Default
Bankruptcy
 ISDA triggering events more broad (e.g., passing resolutions for
winding up or appointment of receiver)
 Failure by Seller to provide reasonable assurances as to future coal
shipments after non-conforming shipments are delivered
 CTA § 8.1(e); Coal Annex, Appendix 1, § 13
23
B. Events of Default
5. CTA v. ISDA Coal Annex (cont.)
 Event of Default in CTA not found in ISDA: Material Adverse
Change
 Parties elect MAC definition on Cover Sheet:
 Credit Rating Trigger (as set by Parties)
 Event that has a material adverse effect on operations, financial
condition or business of a Party as a whole
 Even if MAC occurs, it is not an Event of Default if Defaulting Party
establishes and maintains Performance Assurance for the duration
of the MAC
 Risk Analysis:
 MAC provision mitigates credit risk by entitling a Party to either (i)
receive Performance Assurance, or (ii) declare Event of Default when
the other Party shows signs of financial distress that may not fit cleanly
in another Event of Default
24
B. Events of Default
5. CTA v. ISDA Coal Annex (cont.)
 Events of Default/Termination Events in ISDA not found in CTA:
 Default Under Specified Transaction
 Merger Without Assumption
 Illegality
 Force Majeure Event (2002)
 Tax Event/Tax Event Upon Merger
 Credit Event Upon Merger
25
B. Events of Default
6. Automatic Early Termination under ISDA

How it works:
 Upon occurrence of certain bankruptcy events, an Early Termination
Date is deemed to occur
 Parties do not follow Early Termination Date notice procedures
 Not in standard NAESB, EEI or CTA
 May be useful in jurisdictions without U.S. Bankruptcy Code
“safe harbor” provisions
 Between U.S. counterparties, often not elected:
 Avoids risk of termination without Non-Defaulting Party’s knowledge
 Allows for cure and/or negotiation of better terms
 Avoids risk of unwanted Settlement Payments by Non-Defaulting
Party
26
B. Events of Default
7. Risk Analysis: Events of Default
 Events of Default mitigate credit and payment risks with respect
to the Defaulting Party

More ways to terminate under ISDA than under NAESB, EEI or
CTA, but all may not be necessary for every transaction

Risks of underlying transaction help determine which Events of
Default make sense



Short-Term v. Long-Term
Index Price v. Fixed Price
Automatic Early Termination: May be beneficial under certain
circumstances

May create operational and credit risk if elected in some but not all
contracts with a counterparty
27
C. Setoff
1. 2002 v. 2006 NAESB: § 10.3.2
 Elected on Cover Sheet of both 2002 and 2006 NAESB
 2002 NAESB: Other Agreement Setoff
 If Other Agreement Setoffs apply, bilateral setoff is the only option
 Non-Defaulting Party sets off Net Settlement Amount against:
 Margin or collateral held by Non-Defaulting Party
 Any amounts payable by the Defaulting Party to the Non-Defaulting
Party under any other agreement
28
C. Setoff
1. 2002 v. 2006 NAESB: § 10.3.2 (cont.)

2006 NAESB: Other Agreement Setoffs – 2 Options
 Bilateral Setoff: Same as setoff in 2002 NAESB
 Triangular Setoff: Same as setoff in 2002 NAESB, plus
 Setoff Net Settlement Amount owed to Non-Defaulting Party against
amount(s) owed by Non-Defaulting Party or Affiliates to Defaulting
Party;
 Setoff Net Settlement Amount owed to Defaulting Party against
amount(s) owed by Defaulting Party to Non-Defaulting Party or
Affiliates;
 Setoff Net Settlement Amount owed to Defaulting Party against
amount(s) owed by Defaulting Party or Affiliates to Non-Defaulting
Party
29
C. Setoff
2. 1992 v. 2002 ISDA

1992 ISDA: No setoff provision
 2002 ISDA: Setoff provision in § 6(f)

Non-defaulting Party may setoff Early Termination Amount against
any other amounts owed between the parties
30
C. Setoff
3. NAESB v. ISDA Gas Annex

NAESB § 10.3.2: Election on Cover Sheet

Other Agreement Setoffs Apply:



Other Agreement Setoffs Do Not Apply


2002 NAESB: Bilateral
2006 NAESB: Bilateral or Triangular, as elected by the parties
Setoff limited to amounts owed under the NAESB.
ISDA Gas Annex:

2002 ISDA § 6(f): Setoff provision
 Setoff amounts owed between the parties arising under ISDA or any
other agreement
 No cross-Affiliate setoff
 Identical to setoff in 2002 NAESB
31
C. Setoff
4. EEI v. ISDA Power Annex
 EEI § 5.6: Setoff options elected on Cover Sheet
 Option A: Non-Defaulting Party sets off obligations owed by
Defaulting Party to Non-Defaulting Party under any agreements
between the Parties
 Options B: Non-Defaulting Party sets off obligations owed by
Defaulting Party (or its Affiliates) to the Non-Defaulting Party (or its
Affiliates) under any agreements between the Parties and/or their
Affiliates
 ISDA Power Annex:
 2002 ISDA: Setoff provision in § 6(f)
 Setoff amounts owed between the parties arising under ISDA or any
other agreement
 No cross-Affiliate setoff
32
C. Setoff
5. CTA v. ISDA Coal Annex
 CTA § 8.3
 Upon an Event of Default, Non-Defaulting Party sets off amounts
owed between the Parties under the CTA
 ISDA:
 2002: Setoff provision § 6(f)
 Setoff amounts owed between the parties arising under ISDA or any
other agreement
 No cross-Affiliate setoff
33
C. Setoff
6. Risk Analysis: Risks Mitigated by Setoff
 Commercial Risks:
 Immediately extinguishes payment obligations
 Reduces involvement in bankruptcy proceedings
 Credit Risks:
 Amounts owed by Defaulting Party are immediately setoff
 Cash Flow Risk:
 No waiting for payments from Defaulting Party
 Enterprise-wide risks among Affiliates:
 Manages risk of having to pay Termination Payments across trading
contracts and Affiliates
34
II. Other Agreement Differences
Potentially Creating “Gap Risk”
A.
Termination, Liquidation & Settlement
(NAESB,
ISDA and EEI)
B.
Confirmation Procedures (NAESB, ISDA and CTA)
C.
Netting (NAESB and ISDA)
D.
Transfer and Assignment (CTA and ISDA)
*
35
A. Termination, Liquidation & Settlement
1. 2002 v. 2006 NAESB § 10.3: Terminating Transactions
 2002 and 2006 NAESB: Upon designation of Early Termination
Date, all transactions must be terminated and liquidated, except
for “Excluded Transactions”
 2002 NAESB: Excluded Transactions
 May not be terminated and liquidated under law; and
 Commercially impracticable to terminate in the reasonable opinion
of Non-Defaulting Party
 2006 NAESB: Excluded Transactions
 May not be terminated or liquidated under law
 NOTE: does not include “commercially impracticable” transactions
36
A. Termination, Liquidation & Settlement
1. 2002 v. 2006 NAESB § 10.3: Terminating Transactions
(cont.)
 Risk Analysis:
 Practical Risk: Inability to Liquidate Transactions
 A Non-Defaulting Party under the 2006 NAESB may not be able to
terminate and liquidate certain transactions as of the Early Termination
Date if they are commercially impracticable
 Example: Gas purchases at illiquid Delivery Points
37
A. Termination, Liquidation & Settlement
2. 1992 v. 2002 ISDA § 6: Calculation and Payment of Amounts
Upon Termination
 1992 ISDA § 6(e)
 Market Quotation or Loss calculation method
 One-way or two-way payment (First or Second method)
 2002 ISDA § 6(d)-(e)
 Close-out Amount: Hybrid of Market Quotation and Loss


Calculation of gains, losses and costs incurred in replacing or realizing
the economic equivalent of terminated transactions.
Determining Party may use internal valuations of its losses and costs,
but also must use third-party quotations or market data in valuing
transactions
38
A. Termination, Liquidation & Settlement
2. 1992 v. 2002 ISDA § 6: Calculation and Payment of Amounts
Upon Termination (cont.)
 Risk Analysis:
 Close-out Amount mitigates risk of subjective valuations under Loss
calculation method
 Close-out Amount more flexible than Market Quotation because a
party may look to internal data and estimated losses
 Close-out Amount is more subjective than Market Quotation and
more objective than Loss
39
A. Termination, Liquidation & Settlement
3. NAESB v. ISDA Gas Annex: Calculation and Payments of
Amounts Owed Upon Termination

NAESB § 10.3.1



Non-Defaulting Party determines:

Amount owed by each party for Gas delivered and received on or
before the Termination Date

All other applicable charges related to such deliveries and receipts for
which payment has not yet been made
If “Additional Termination Damages” apply:

Liquidation and acceleration of Terminated Transactions at Market
Value

If Market Value greater than Contract Value, difference due to Buyer

If Market Value less than Contract Value, difference due to Seller
Default two-way payment
40
A. Termination, Liquidation & Settlement
3. NAESB v. ISDA Gas Annex: Calculation and Payment of
Amounts Owed Upon Termination (cont.)

ISDA § 6(e): Market Quotation and Loss


Market Quotation:

Value of Terminated Transactions based on quotations from ReferenceMarket Makers plus any Unpaid Amounts owed to Non-Defaulting
Party; minus

Unpaid Amounts owed to the Defaulting Party
Loss:


Non-Defaulting Party’s total losses and costs resulting from early
termination and liquidation, including loss of bargain, costs of funding,
and costs of terminating, liquidating or reestablishing any hedge
ISDA § 6(e): First and Second Method

One-way v. two-way payment
41
A. Termination, Liquidation & Settlement
4. EEI v. ISDA Power Annex: Calculation and Payment of
Amounts Owed Upon Termination
 EEI:
 § 5.2: Non-Defaulting Party calculates Settlement Amount for each
Terminated Transaction in a “commercially reasonable manner”
 § 5.3: Settlement Amounts netted into Termination Payment,
payable either to or from the Non-Defaulting Party
 Default two-way payment unless changed by parties
 ISDA:
 § 6(e): Market Quotation or Loss, as elected by parties
 ISDA § 6(e): First or Second Method, as elected by the parties
(one-way or two-way payment)
42
A. Termination, Liquidation & Settlement
5. NAESB, EEI and ISDA: Risk Analysis

Inherent operational risks in various calculation methods:

NAESB method and Market Quotation are substantively similar,
while EEI requires calculation in a “commercially reasonable
manner”

Use of market quotes may not accurately reflect actual or
anticipated value of transactions

Subjective nature of Loss calculation
 Inconsistent Payment Risks to Defaulting Party:

NAESB and EEI are two-way payment

Potential exposure if one-way payment elected in ISDA
43
B. Confirmation Procedures
1. NAESB v. ISDA Gas Annex

NAESB § 1.2: Procedure elected on Cover Sheet

Oral Transaction Procedure



Transaction is binding when parties orally agree upon terms
Failure to send Transaction Confirmation does not affect performance
obligations
Written Transaction Procedure

Parties must exchange non-conflicting Transaction Confirmation before
parties legally obligated to perform
*
44
B. Confirmation Procedures
1. NAESB v. ISDA Gas Annex (cont.)

ISDA § 9(e)(ii):

Parties legally bound from the moment they agree on commercial
terms

Confirm Transaction terms by sending written Confirmations

No other specific terms or procedures in form ISDA
45
B. Confirmation Procedures
2. CTA v. ISDA Coal Annex
 CTA § 1.1
 Parties are bound when terms agreed upon (whether oral or written)
 Buyer shall provide Confirmation with commercial terms
 If Seller disputes terms, Parties use “commercially reasonable
efforts” to resolve the dispute within ten (10) Business Days
 If dispute cannot be resolved, Parties may seek “any other remedy”
under the CTA
 ISDA § 9.2(e)(ii)

Parties legally bound from the moment they agree on commercial
terms, and confirm by sending written Confirmations
*
46
B. Confirmation Procedures
3. NAESB, CTA and ISDA: Risk Analysis

Confirmation procedures should conform to risk in underlying
transactions
 Short-term v. Long-term
 Risk of disagreement regarding future performance obligations
 Operational Risk in Confirming Transactions
 Buyer confirms in CTA, Seller confirms in NAESB and ISDA does
not specify
 Inconsistent Dispute Resolution Procedures
 NAESB and CTA v. ISDA
*
47
C. Netting
1. NAESB v. ISDA Gas Annex

NAESB § 7.7




ISDA § 2(c)



All payments due and owing (or past due and owing) netted into
single amount
The party owing the greater amount shall make a single payment to
the other party
Not limited to amounts owed under a single transaction
Netting generally limited to amounts due (i) on the same date; (ii) in
the same currency; and (iii) in respect of the same Transaction.
Can be modified by the parties in the Schedule
Risk Analysis:

Inconsistent netting provisions across multiple agreements may
create cash flow and operational risks

Cross-Transactional Netting: NAESB v. ISDA
*
48
D. Transfer and Assignment
1. CTA v. ISDA Coal Annex
 General Rule: No transfer or assignment without prior written
consent of other party (CTA § 10.1; ISDA § 7)
 CTA: Consent cannot be unreasonably withheld or delayed
 ISDA: No “reasonableness” requirement
 Exceptions in CTA:
 Financing or financial arrangements
 Affiliate at least as creditworthy as assignor
 Person succeeding to all or substantially all of Party’s assets
(merger, reorganization, or otherwise)
49
D. Transfer and Assignment
1. CTA v. ISDA Coal Annex (cont.)


Exceptions in ISDA:

Transfers of rights to receive Termination Payments from
Defaulting Party

Consolidation, merger or transfer of all assets
Risk Analysis:

CTA provides more flexibility

ISDA may make transfers more difficult, time consuming and
expensive
*
50
Conclusion

Differences exist between trading agreements

May be difficult to make all agreements consistent

Identify priority issues

Scope

Research paper
Craig R. Enochs
cenochs@jw.com
Jackson Walker L.L.P.
1401 McKinney, Suite 1900
Houston, Texas 77010
(713) 752-4200 phone
*
51