FAILURE TO DELIVER OR RECEIVE NATURAL GAS Including Adequate Assurances, Cover, and Force Majeure

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1 Presented: The University of Houston Law Foundation Oil, Gas and Energy Law May 1-2, 2008 Houston, Texas May 8-9, 2008 Dallas, Texas FAILURE TO DELIVER OR RECEIVE NATURAL GAS Including Adequate Assurances, Cover, and Force Majeure Craig R. Enochs Kevin M. Page Jackson Walker L.L.P. 1

2 The term master agreement generally means an agreement, often standardized for a commodity, with terms and conditions that will apply to multiple transactions, each evidenced by a transaction confirmation. The NAESB Base Contract for Sale and Purchase of Natural Gas ( NAESB ) 1 is the master agreement most commonly used to document natural gas ( Gas ) transactions. One of the fundamental risks in a Gas purchase and sale transaction is that the other party may fail to deliver or receive the Gas. The express remedy under the NAESB for such nonperformance is liquidated damages, 2 but the performing party may also have recourse to adequate assurances of performance or the early termination and liquidation of the NAESB. The Uniform Commercial Code, codified in Texas as Title 1 of the Texas Business and Commerce Code 3 (hereinafter, the Code ), contains fallback provisions when a contract is ambiguous or fails to address an issue. 4 Although most Gas transactions are entered into pursuant to a NAESB, this is not always the case. Accordingly, this paper will analyze the rights of the performing party under both the Code and the NAESB when the other party fails to deliver or receive Gas. I. The Code A. In General 1. Right to modify Code terms Section of the Code gives the parties to a contract the ability to vary the terms of the Code as it applies to their relationship. This is important for two reasons. First, it provides the parties the flexibility to contract around, or out of, the Code s contractual remedies provisions. Second, it serves as a warning that there may be instances in which an issue may be resolved pursuant to 1 For purposes herein, all citations and references to the NAESB shall be to the version published by the North American Energy Standards Board, Inc. on September 5, See NAESB See Tex. Bus. & Com. Code Ann., Title 1, et seq. 4 See Tex. Bus. & Com. Code Ann.,

3 the Code despite it being addressed in a contract because the terms of the contract are determined to lack the specificity or clarity required to preclude the application of the Code. 2. Perfect Tender rule The Code espouses what is commonly known as the perfect tender rule, which provides that any failure to conform to the obligations stated in the contract, regardless of how minor the deviation, constitutes a breach of the contract. 5 Under Section 2.601, the seller breaches the contract if its delivery fails in any respect to conform to the contract. 6 However, Section somewhat relaxes the perfect tender rule by allowing the seller to cure any improper tender if the time for performance has not yet expired Installment contracts The Code treats the breach of an installment contract differently from the breach of other contracts. This is particularly relevant to energy contracts, as most energy-related master agreements fall within the Code s definition of installment contract as a contract which requires or authorizes the delivery of goods in separate lots to be separately accepted, even though the contract contains a clause each delivery is a separate contract or its equivalent. 8 The buyer may reject any installment that is non-conforming if the non-conformity substantially impairs only the value of the single installment and cannot be cured. 9 However, if the nonconformity does not impair the value of the contract as a whole, subsection (b) provides that the buyer must accept the non-conforming installment if the seller can give assurances that it will cure the non-conformity with respect to the installment. 10 Subsection (c) provides that whenever a non-conformity with respect to one or more installments substantially impairs the value of the 5 See Tex. Bus. & Com. Code Ann ; Tex. Bus. & Com. Code Ann.. Conformity does not mean substantial performance; it means complete, perfect performance. Tex. Imps. v. Allday, 649 S.W.2d 730, (Tex. App. Tyler 1983, writ ref d n.r.e); Printing Ctr., Inc. v. Supermind Publ g Co., 669 S.W.2d 779, (Tex. App. Houston [14 th Dist.] 1984, no writ). 7 Tex. Bus. & Com. Code Ann Tex. Bus. & Com. Code Ann (a). See Tex. Bus. & Com. Code Ann , cmt. 3 (stating [t]his Article rejects any approach which gives clauses such as each delivery is a separate contract their legalistically literal effect. Such contracts nonetheless call for installment deliveries. Even where a clause speaks of a separate contract for all purposes, a commercial reading of the language under the section on good faith and commercial standards requires that the singleness of the document and the negotiation, together with the sense of the situation, prevail over any uncommercial and legalistic interpretation. ). 9 Tex. Bus. & Com. Code Ann (b). 10 Id. 3

4 whole contract there is a breach of the whole. 11 Whether the non-conformity in any given installment justifies cancellation of all future transactions depends not on whether such nonconformity indicates an intent or likelihood that the future deliveries will also be defective, but whether the non-conformity substantially impairs the value of the whole contract. 12 If only the seller s security in regard to future installments is impaired, it may demand adequate assurances of proper future performance but does not have the immediate right to cancel the whole contract. 13 Defects in installments are cumulative in effect, which means that acceptance does not wash out the defect waived. 14 B. Seller s Remedies Section of the Code lists the remedies available to the seller in the event of a breach by the buyer. 15 It allows an aggrieved seller to withhold delivery, stop delivery of goods already in transit, resell the goods and recover damages, recover damages for non-acceptance, or terminate the contract when the buyer wrongfully rejects or revokes acceptance of conforming goods, fails to make a payment due, or repudiates any part of the contract. 16 Section of the Code allows the seller to resell goods wrongfully rejected by the buyer or the undelivered balance of any goods identified to the contract. 17 Where the resale is made in good faith and in a commercially reasonable manner the seller may recover the difference 11 Tex. Bus. & Com. Code Ann (c). 12 Tex. Bus. & Com. Code Ann , cmt Id. 14 Id. 15 Or, as stated in the comment, it gathers together in one convenient place all of the various remedies open to a seller for any breach by the buyer. Tex. Bus. & Com. Code Ann , cmt Tex. Bus. & Com. Code Ann (stating that [w]here the buyer wrongfully rejects or revokes acceptance of goods or fails to make a payment due on or before delivery or repudiates with respect to a part or the whole, then with respect to any goods directly affected and, if the breach is of the whole contract (Section 2.612), then also with respect to the whole undelivered balance, the aggrieved seller may (1) withhold delivery of such goods; (2) stop delivery by any bailee as hereafter provided (Section 2.705); (3) proceed under the next section respecting goods still unidentified to the contract; (4) resell and recover damages as hereafter provided (Section 2.706); (5) recover damages for non-acceptance (Section 2.708) or in a proper case the price (Section 2.709); (6) cancel. ). 17 Tex. Bus. & Com. Code Ann (a) (stating that [u]nder the conditions stated in Section 2.703, on seller s remedies, the seller may resell the goods concerned or the undelivered balance thereof. Where the resale is made in good faith and in a commercially reasonable manner the seller may recover the difference between the resale price and the contract price together with any incidental damages allowed under the provisions of this chapter (Section 2.710) but less expenses saved in consequence of the buyer s breach. ). 4

5 between the resale price and the contract price together with any incidental damages [incurred as a result of the resale], but less expenses saved in consequence of the buyer s breach. 18 The Code requires that all aspects of the resale, including its time, place, manner and terms, be carried out in a commercially reasonable manner. 19 In conducting a public or private resale of goods, the seller must strictly abide by statutory conditions such as providing the buyer with notice of the sale to ensure that the sale is commercially reasonable. 20 If the seller fails to meet any of the Code s conditions surrounding a public or private sale, the seller will not be entitled to recover damages under Section However, the seller s inability to meet all such conditions under Section does not necessarily preclude the seller s right to seek damages under Section of the Code. 22 If the seller elects not to seek damages upon a resale of goods under Section (or otherwise cannot meet all statutory elements to receive such damages), Section provides an alternative remedy relating to the buyer s non-acceptance of goods or repudiation of the contract. 23 The seller s measure of damages for the buyer s non-acceptance or repudiation is the difference between market price (at the time and place for tender) and the unpaid contract price, as well as any incidental damages allowed under Section However, any expenses that the seller saved as a result of the buyer s breach must be subtracted from the seller s damages calculation Tex. Bus. & Com. Code Ann (a). 19 Tex. Bus. & Com. Code Ann (b). 20 See Tex. Bus. & Com. Code Ann (b)-(c). 21 See, e.g., Plano Lincoln Mercury v. Roberts, 167 S.W.3d 616, (Tex. App. Dallas 2005) (Seller s failure to give actual notice to buyer of private resale precludes recovery of damages under Section of the Code); Cook Composites, Inc. v. Westlake Styrene Corp., 15 S.W.3d 124, 137 (Tex. App. Houston [14 th Dist.] 2000, pet. dism d) (Recovery under Section of the Code is precluded if the seller does not prove both (1) presale notice; and (2) commercial reasonableness). 22 See Roberts, 167 S.W.3d at ; Cook Composites, 15 S.W.3d at 138 (Both cases note that comment 2 to Section provides that a seller s failure to comply with procedural provisions under Section still leaves the seller with a remedy under Section of the Code). 23 See Tex. Bus. & Com. Code Ann (a). 24 Id.; In determining market price, Section of the Code provides a procedure to obtain a substitute market price where a price may not be readily available at the time and place of tender. See Tex. Bus. & Com. Code Ann (b). 25 Tex. Bus. & Com. Code Ann (a). 5

6 Section further provides that if the calculation of damages described in the preceding paragraph is inadequate to put the seller in as good a position as it would have occupied had the buyer performed its obligations, then non-acceptance or repudiation damages are measured as (i) the profit (including reasonable overhead) that the seller would have made from full performance by the buyer, plus (ii) any incidental damages incurred by the seller (as allowed under Section 2.710) along with costs reasonably incurred by the seller, minus (iii) any payments or proceeds the seller received from any resale. 26 C. Buyer s Remedies Section outlines the remedies generally available under Article 2 to the buyer in the event of a breach by the seller. 27 Subsection (a) provides that when the seller fails to make delivery or the buyer rightfully rejects or revokes acceptance, the buyer may terminate the contract, recover the price paid, and either cover and receive damages (as discussed below), or receive damages for non-delivery. 28 In the case of the seller s failure to deliver or repudiation, subsection (b) allows the buyer the option of (1) recovering the goods (if the goods have been identified to the contract), (2) obtaining specific performance, or (3) replevying the goods. 29 Subsection (c) offers yet another option by creating an automatic security interest in goods in the buyer s possession or control for any payments made on those goods and any expenses incurred in the receipt, inspection, transportation, care and custody of the goods. 30 If the seller delivers any non-conforming goods, this section allows the buyer to sell such goods in the buyer s possession 26 See Tex. Bus. & Com. Code Ann (b). 27 Tex. Bus. & Com. Code Ann (stating (a) Where the seller fails to make delivery or repudiates or the buyer rightfully rejects or justifiably revokes acceptance then with respect to any goods involved, and with respect to the whole if the breach goes to the whole contract, the buyer may cancel and whether or not he has done so may in addition to recovering so much of the price as has been paid (1) cover and have damages under the next section as to all goods affected whether or not they have been identified to the contract; or (2) recover damages for nondelivery as provided in this chapter; (b) Where the seller fails to deliver or repudiates the buyer may also (1) if the goods have been identified recover them as provided in this chapter (Section 2.502); or (2) in a proper case obtain specific performance or replevy the goods as provided in this chapter (Section 2.716); (c) On rightful rejection or justifiable revocation of acceptance a buyer has a security interest in goods in his possession or control for any payments made on their price and any expenses reasonably incurred in their inspection, receipt, transportation, care and custody and may hold such goods and resell them in like manner as an aggrieved seller. ). 28 Tex. Bus. & Com. Code Ann (a). 29 Tex. Bus. & Com. Code Ann (b). 30 See Tex. Bus. & Com. Code Ann (c). 6

7 as though it were the seller exercising its rights under Section However, Article 2 does not allow the buyer automatically to cancel the entire contract if the seller fails to deliver only one installment of conforming goods. 32 Section 2.711, when read with other applicable Article 2 provisions, provides for cancellation of the entire contract only when the seller s breach goes to the whole contract, which requires that the breach must impair the value of the entire contract. 33 In addition, Section allows the buyer to terminate the contract if the buyer receives notification of a material reduction or indefinite delay in delivery resulting from the seller s proper excuse for performance. 34 Upon the seller s breach, Section allows the buyer to cover by purchasing goods to substitute for those due from the seller. 35 The statute sets forth specific conditions relating to the buyer s ability to cover, providing that (i) cover must be done in good faith; (ii) cover must be done without unreasonable delay; and (iii) the purchase of (or contract to purchase) substitute goods must be reasonable. 36 If the buyer properly covers after the seller s breach, the buyer is entitled to recover from the seller as damages the difference between the cost of cover and the contract price, as well as any incidental or consequential damages (as set forth in Section 2.715). 37 However, any expenses the buyer saved as a result of the seller s breach must be subtracted from the buyer s damage calculation Id. 32 See Tex. Bus. & Com. Code Ann (a); Id. Section deals primarily with installment contracts. Under this section, a breach by either the seller or the buyer may impair either the installment in question, or the contract as a whole. Whether the non-conformity in any given installment is substantial enough to warrant cancellation of all future installments depends on the likelihood of whether any future deliveries will also be defective, as well as whether the non-conformity substantially impairs the value of the whole contract. Substantial impairment may be based on any number of factors, including the quality of the goods and the time of delivery. Comment 6 to Section specifically states, however, that where the only impairment is the seller s security in regard to future installments, the seller may demand adequate assurances of future performance, but does not have the right to immediately cancel the contract. However, it is important to note that defects in the performance of either the buyer or the seller are cumulative in effect. This section also provides that a buyer who accepts a non-conforming installment, or who does not receive an installment, may withhold his decision as to whether or not to cancel the entire contract pending a response from the seller as to any request for cure or adjustment. A seller also may withhold delivery of future shipments pending the receipt of payment for any prior shipments, and withhold his decision regarding cancellation. 34 See Tex. Bus. & Com. Code Ann (a) and infra at Section IV(A), pg See Tex. Bus. & Com. Code Ann (a). 36 Id. 37 See Tex. Bus. & Com. Code Ann (b); see also Tex. Bus. & Com. Code Ann (stating that Incidental damages include, but are not limited to, any commercially reasonable charges, expenses or commissions in connection with effecting cover and any other reasonable expenses incident to delay or other 7

8 If the buyer does not seek cover damages under Section 2.712, upon the seller s non-delivery or repudiation, the buyer can recover from the seller as damages the difference between the market price at the time when the buyer learned of the seller s breach and the contract price, as well as any incidental or consequential damages. 39 However, the buyer must subtract from its damage calculation any costs or expenses the buyer saved as a result of the seller s breach. 40 In determining the relevant market price, the Code requires that the buyer rely on the price as of the place for tender [of the goods] or, in cases of rejection after arrival or revocation of acceptance, as of the place of arrival of the goods. 41 Moreover, Section provides the procedure for obtaining a substitute market price in situations where a market price may not be readily available at the place of tender or arrival. 42 The Code affords buyers unique, equitable remedies of specific performance and/or replevin in very limited circumstances. Section provides that the buyer may seek specific performance of the contract from the seller where the goods are unique or in other proper circumstances. 43 Any decree of specific performance may include terms and conditions relating to payment of the price, damages or other relief as the court deems just. 44 Similarly, [t]he buyer has a right of replevin for goods identified to the contract if after reasonable effort [the buyer] is unable to effect cover for such goods or the circumstances reasonably indicate that such effort will be unavailing. 45 D. Adequate Assurances of Performance breach. Consequential damages include, but are not limited to, any loss resulting from general or particular requirements and needs of which the seller at the time of the contracting had reason to know and which could not reasonably be prevented by cover or otherwise ). 38 Tex. Bus. & Com. Code Ann (b). 39 See Tex. Bus. & Com. Code Ann (a). 40 Id. 41 See Tex. Bus. & Com. Code Ann (b). 42 See Tex. Bus. & Com. Code Ann (b). 43 Tex. Bus. & Com. Code Ann (a). 44 Tex. Bus. & Com. Code Ann (b). 45 Tex. Bus. & Com. Code Ann (c). 8

9 The Code permits either party to request and receive assurances of performance when a breach has not yet occurred if the counterparty s performance, or continued ability to perform, has been called into question. 46 This right is premised on the commercial reality that (i) the seller needs to be able to protect against the risk of having to deliver a commodity on credit to an unreliable buyer, as well as the risk of having to procure goods for such buyer, which could necessitate turning away other creditworthy buyers; and (ii) the buyer may need to take action to protect against the risk of the seller s non-performance prior to the date performance is due when any failure by the seller at that point could seriously impair the buyer s business. 47 Either party may request adequate assurances of performance when it has reasonable grounds for insecurity and may, if commercially reasonable, suspend its own performance for which it has not already received the agreed return until it receives such assurances. 48 A party must make a written request to the other party demanding assurances of performance and may treat a failure to provide adequate assurances within a reasonable period of time of the request as a repudiation of the contract. 49 The reasonableness of a request for assurance and the adequacy of the assurance offered will be determined according to commercial standards. 50 Further, acceptance by the seller of a partial payment, or by the buyer of nonconforming goods, does not prejudice the party s right to receive assurances under this section. 51 The Code also addresses anticipatory repudiation by either party and provides that (i) when a party repudiates the contract by declaring that performance not yet due under the contract will 46 Tex. Bus. & Com. Code Ann See Tex. Bus. & Com. Code Ann , cmt See Tex. Bus. & Com. Code Ann (stating (a) A contract for sale imposes an obligation on each party that the other s expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return; (b) Between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards; (c) Acceptance of any improper delivery or payment does not prejudice the aggrieved party s right to demand adequate assurance of future performance; (d) After receipt of a justified demand failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract. ). 49 Id. 50 Tex. Bus. & Com. Code Ann (b). 51 Tex. Bus. & Com. Code Ann (c). 9

10 not be rendered, and (ii) if such failure to perform will substantially impair the value of the contract, then the aggrieved party may either await performance by the repudiating party for a commercially reasonable time 52 or resort to any remedy available for breach, but in either case may suspend its own performance. 53 Anticipatory repudiation is defined as an overt communication of intention or an action which renders performance impossible or demonstrates a clear determination not to continue with performance. 54 To constitute repudiation, it is not necessary that performance be made literally and utterly impossible. 55 Repudiation can result from any action that reasonably indicates a rejection of the continuing obligation. 56 However, the Code also allows a party to retract its repudiation any time before the next performance is due under the contract unless the aggrieved party has since the repudiation cancelled or materially changed his position or otherwise indicated that he considers the repudiation final. 57 Retraction may be made by any method which clearly indicates to the aggrieved party that the repudiating party intends to perform, but must include any assurance justifiably demanded. 58 Retraction reinstates the repudiating party s rights under the contract but requires the repudiating party to answer to the aggrieved party in damages for any delay occasioned by the repudiation. 59 II. NAESB A. Liquidated Damages Section 3.2 of the NAESB permits the other party to collect liquidated damages in the event the seller fails to deliver, or the buyer fails to receive, quantities of Gas agreed to in a transaction. 52 Tex. Bus. & Com. Code Ann , cmt. 1 (stating that if the aggrieved party awaits performance beyond a commercially reasonable time, he cannot recover resulting damages which he should have avoided by taking action). 53 TEX. BUS. COM. C (stating that [w] hen either party repudiates the contract with respect to a performance not yet due the loss of which will substantially impair the value of the contract to the other, the aggrieved party may (1) for a commercially reasonable time await performance by the repudiating party; or (2) resort to any remedy for breach, even though he has notified the repudiating party that he would await the latter's performance and has urged retraction; and (3) in either case suspend his own performance or proceed in accordance with the provisions of this chapter on the seller's right to identify goods to the contract notwithstanding breach or to salvage unfinished goods. ). 54 See Tex. Bus. & Com. Code Ann , cmt Tex. Bus. & Com. Code Ann , cmt Id. 57 See Tex. Bus. & Com. Code Ann (a). 58 Tex. Bus. & Com. Code Ann (b). 59 Tex. Bus. & Com. Code Ann (c). 10

11 The NAESB requires the parties to elect to use either the Cover Standard or the Spot Price Standard for calculating liquidated damages. 60 The Cover Standard provides for the recovery of the difference between (i) the contract price, and (ii) the market price at which the quantities not received by the buyer are resold by the seller or at which substitute quantities of Gas or an alternate fuel are purchased by the buyer. 61 The non-breaching party must use commercially reasonable efforts to obtain a market price that is reasonable for the delivery point or production area. 62 The reasonableness of the price received or paid for Gas may be affected by several factors, including the amount of notice provided by the nonperforming party; the immediacy of the Buyer s Gas consumption needs or Seller s Gas sales requirements, as applicable; the quantities involved; and the anticipated length of failure by the nonperforming party. 63 If the seller fails to deliver the Gas as required by the contract, the seller must pay to the buyer (i) the difference between the purchase price paid by the buyer utilizing the Cover Standard and the 60 NAESB 3.2. (defining Cover Standard as [t]he sole and exclusive remedy of the parties in the event of a breach of a Firm obligation to deliver or receive Gas shall be recovery of the following: (i) in the event of a breach by Seller on any Day(s), payment by Seller to Buyer in an amount equal to the positive difference, if any, between the purchase price paid by buyer utilizing the Cover Standard and the Contract Price, adjusted for commercially reasonable differences in transportation costs to or from the Delivery Point(s), multiplied by the difference between the Contract Quantity and the quantity actually delivered by Seller for such Day(s) excluding any quantity for which no replacement is available; or (ii) in the event of a breach by Buyer on any Day(s), payment by Buyer to Seller in the amount equal to the positive difference, if any, between the Contract Price and the price received by Seller utilizing the Cover Standard for the resale of such Gas, adjusted for commercially reasonable differences in transportation costs to or from the Delivery Point(s) multiplied by the difference between the Contract Quantity and the quantity actually taken by Buyer for such Day(s) excluding any quantity for which no sale is available; and (iii) in the event that Buyer has used commercially reasonable efforts to replace the Gas or Seller has used commercially reasonable efforts to sell the Gas to a third party, and no such replacement or sale is available for all or any portion of the Contract Quantity of Gas, then in addition to (i) or (ii) above, as applicable, the sole and exclusive remedy of the performing party with respect to the Gas not replaced or sold shall be an amount equal to any unfavorable difference between the Contract Price and the Spot Price, adjusted for such transportation to the applicable Delivery Point, multiplied by the quantity of such Gas not replaced or sold. Imbalance Charges shall not be recovered under this Section 3.2, but Seller and/or Buyer shall be responsible for Imbalance Charges, if any, as provided in Section 4.3. The amount of such unfavorable difference shall be payable five Business Days after presentation of the performing party s invoice, which shall set forth the basis upon which such amount was calculated. ). 61 See Id. 62 NAESB 2.12 (providing that Cover Standard shall mean that if there is an unexcused failure to take or deliver any quantity of Gas pursuant to this Contract, then the performing party shall use commercially reasonable efforts to (i) if Buyer is the performing party, obtain Gas (or an alternate fuel if elected by Buyer and Gas is not available), or (ii) if Seller is the performing party, sell Gas, in either case, at a price reasonable for the delivery or production area, as applicable, consistent with: the amount of notice provided by the nonperforming party; the immediacy of the Buyer s Gas consumption needs or Seller s Gas sales requirements, as applicable; the quantities involved; and the anticipated length of failure by the nonperforming party ). 63 Id. 11

12 contract price, multiplied by (ii) the difference between the contract quantity and the quantity actually delivered by the seller for such days (excluding any quantity for which no replacement is available). 64 Similarly, if the buyer fails to receive the Gas as required by the contract, the buyer must pay to the seller (i) the difference between the contract price and the price received by the seller utilizing the Cover Standard, multiplied by (ii) the difference between the contract quantity and the quantity actually taken by the buyer for such days (excluding any quantity for which no sale is available). 65 The damages calculated pursuant to this method will, in both instances, be adjusted for commercially reasonable differences in transportation costs to or from the delivery points. 66 For those Gas volumes for which no replacement purchase or sale is available after reasonable efforts are expended to obtain such replacement, then the damages for such volumes shall equal any unfavorable difference between the Contract Price and the Spot Price, adjusted for such transportation to the applicable Delivery Point, multiplied by the quantity of such Gas not replaced or sold. 67 The Spot Price Standard sets forth a materially different method of calculating damages. 68 If a party fails to deliver or receive Gas as required by a transaction, the non-performing party must pay to the performing party (i) the difference between the contract price and the Spot Price, multiplied by (ii) the difference between the contract quantity and the actual quantity delivered by the seller and received by the buyer. 69 Spot Price is defined as the price listed in the 64 NAESB Id. 66 Id. 67 Id. 68 Id. (defining Spot Price Standard as [t]he sole and exclusive remedy of the parties in the event of a breach of a Firm obligation to deliver or receive Gas shall be recovery of the following: (i) in the event of a breach by Seller on any Day(s), payment by Seller to Buyer in an amount equal to the difference between the Contract Quantity and the actual quantity delivered by Seller and received by buyer for such Day(s), multiplied by the positive difference, if any, obtained by subtracting the Contract Price from the Spot Price; or (ii) in the event of a breach by Buyer on any Day(s), payment by Buyer to Seller in an amount equal to the difference between the Contract Quantity and the actual quantity delivered by Seller and received by Buyer for such Day(s), multiplied by the positive difference, if any, obtained by subtracting the applicable Spot Price from the Contract Price. Imbalance Charges shall not be recovered under this Section 3.2, but Seller and/or Buyer shall be responsible for Imbalance Charges, if any, as provided in Section 4.3. The amount of such unfavorable difference shall be payable five Business Days after presentation of the performing party s invoice, which shall set forth the basis upon which such amount was calculated. ). 69 Id. 12

13 publication indicated on the Base Contract for the geographic location in closest proximity to the delivery points for the relevant days. 70 Both standards provide that all charges assessed against the non-performing party must be paid within five Business Days after the presentation of the performing party s invoice setting forth the basis upon which such amount was calculated. 71 Notably, both the Cover Standard and the Spot Price Standard expressly address the payment of imbalance charges and provide that such charges will be paid by the party whose act or omission caused such charges to be imposed. 72 The NAESB allows the parties to elect an alternative measure of damages in a Transaction Confirmation if they are dissatisfied with opting between the Cover Standard and the Spot Price Standard. 73 B. Adequate Assurance of Performance The NAESB allows either party to demand adequate assurance of performance if the demanding party has reasonable grounds for insecurity regarding the performance of any obligation by the other party, whether or not the obligation is then due. 74 A reasonable ground for insecurity 70 NAESB This section refers to the price listed in the publication indicated on the Base Contract; thus, if the parties choose the Spot Price Standard for calculating damages, the parties must then select a reliable market publication that will allow them to determine the spot price on any given day. This section also provides that if there is no single spot price published for a particular location on a particular day, but there is a published range of prices, then the spot price will be the average of the highest and lowest prices listed. If there is no range of prices published, then the spot price will be the average of (1) the price for the first day for which a price or range of prices is published that next precedes the day(s) of the breach, and (2) the price for the first day for which a price or range of prices is published after the day of the breach. 71 NAESB NAESB 4.3 (providing that [t]he parties shall use commercially reasonable efforts to avoid the imposition of Imbalance Charges. If Buyer or Seller receives an invoice from a Transporter that includes imbalance charges, the parties shall determine the validity as well as the cause of such Imbalance Charges. If the Imbalance Charges were incurred as a result of Buyer s receipt of quantities of Gas greater than or less than the Scheduled Gas, then Buyer shall pay for such Imbalance Charges or reimburse Seller for such Imbalance charges paid by Seller. If the Imbalance Charges were incurred as a result of Seller s deliver of quantities of Gas greater than or less than the Scheduled Gas, then Seller shall pay for such Imbalance Charges or reimburse buyer for such Imbalance Charges paid by Buyer. ) 73 NAESB NAESB

14 specifically includes the occurrence of a material change in the creditworthiness of the party or its guarantor, if any. 75 The NAESB describes adequate assurance of performance as sufficient security in a form, amount, and term reasonably acceptable to the requesting party, which may include cash, a letter of credit, a prepayment, a security interest, or a guaranty. 76 A failure to provide properly requested adequate assurance within forty-eight hours (but at least one Business Day) of the request constitutes an Event of Default. 77 Adequate assurances of performance under the NAESB often are thought of as strictly a credit tool, but also could be used when the other party fails to deliver or receive Gas. 78 Although Section 3.2 describes the remedy therein as the exclusive remedy for a failure to deliver or receive Gas, 79 the rights available under Section 10.1 could be argued to be an independent right triggered by the failure to deliver or receive Gas but not in themselves remedies for such failure. 80 However, the amount a party might demand probably would be limited to an amount close to the anticipated liquidated damages owed following such failure, in order to comply with the reasonableness requirement of Section C. Early Termination and Liquidation Most master agreements, including the NAESB, permit the non-defaulting party to terminate the master agreement and liquidate all transactions upon the occurrence of an event of default. 82 Under the NAESB, this is a right and not an obligation, permitting the non-defaulting party to wait before terminating and liquidating transactions or to decide not to terminate and liquidate at all Id. 76 Id. 77 NAESB The Code also permits the request of adequate assurances for non-credit related concerns. See TEX. BUS. & COM. C and supra at Section I(D), pgs NAESB NAESB See NAESB See, e.g., NAESB Id. 14

15 The NAESB sets forth specific acts and omissions of either a party or a party s guarantor that constitute Events of Default, including: (1) failing to give adequate assurance of performance within forty-eight hours after a request; (2) failing to pay any amount due on or before the second business day following written notice that such payment is due; (3) making an assignment or any general arrangement for the benefit of creditors; (4) filing a petition in bankruptcy; and (5) being unable to pay debts as they become due. 84 Neither the seller s failure to comply with its delivery obligations nor the buyer s failure to receive the amount of Gas contracted for constitutes an Event of Default under the standard NAESB. 85 However, buyers for whom the delivery of physical Gas is more important than liquidated damages 86 often will add special provisions to the NAESB creating an Event of Default if the seller fails to deliver Gas for a certain number of consecutive days and/or for a certain number of cumulative days within a defined time period. 87 Upon the occurrence of an Event of Default, the non-defaulting party may withhold or suspend deliveries or payments upon notice to the defaulting party 88 or designate an early termination date on which all transactions under the NAESB will be terminated and liquidated. 89 If the parties have elected on the cover sheet that early termination damages will apply, the nondefaulting party will determine the amount owed by each party with respect to all Gas delivered and received on or before the early termination date and the market value of each terminated transaction. 90 The non-defaulting party will then liquidate each terminated transaction at its market value. 91 If the market value exceeds the contract value, a termination payment will be owed to the buyer; and if the contract value exceeds the market value, a payment will be owed to 84 NAESB See id. 86 These buyers might include local distribution companies, who are obligated to deliver natural gas to their retail customers, or buyers purchasing gas at an illiquid delivery point where replacement Gas may be difficult to obtain. 87 E.g., an event of default might be created for a failure to deliver Gas for five consecutive days or ten total days in any month. 88 NAESB Id., NAESB See NAESB Id. 15

16 the seller. 92 The amount calculated using this formula will be discounted to present value in a commercially reasonable manner. 93 If the parties have elected on the cover sheet that early termination damages do not apply, then, as of the early termination date, the non-defaulting party will determine in good faith and in a commercially reasonable manner the amount owed by each party for which payment has not yet been made with respect to all Gas delivered and received between the parties in the terminated transactions on or before the early termination date, and the only payment owed between the parties will be this amount. 94 Although the non-defaulting party may terminate the NAESB upon the occurrence of an Event of Default, careful consideration should be given as to whether this right should be exercised. It may seem counterintuitive that a party, upon the conferral of a right to take action in light of the other party s breach, would prefer to delay or not to exercise that right. However, the early termination and liquidation remedy is one of great finality and significance, and a party might wish to delay its exercise if: (i) it did not wish to end the trading relationship with the defaulting party; (ii) it believed the defaulting party was going to cure the Event of Default with no lasting harm to either party; (iii) the non-defaulting party would owe the defaulting party the settlement payment; or (iv) the non-defaulting party desired to use the threat of terminating and liquidating the master agreement as leverage to negotiate an agreement of some sort with the defaulting party while continuing the trading relationship Id. (stating that Market Value means the amount of Gas remaining to be delivered or purchased under a transaction multiplied by the market price for a similar transaction at the Delivery Point determined by the Non- Defaulting party in a commercially reasonable manner. To ascertain the Market Value, the Non-Defaulting party may consider, among other valuations, any or all of the settlement prices of NYMEX Gas futures contracts, quotations from leading dealers in energy swap contracts or physical gas trading markets, similar sales or purchases and any other bona fide third-party offers, all adjusted for the length of the term and differences in transportation costs. Contract Value means the amount of Gas remaining to be delivered or purchased under a transaction multiplied by the Contract Price. ) 93 See NAESB Id. 95 Any such agreement would likely relate to performance assurance and/or other agreements between the parties and/or their affiliates. This is often the case when the other contracts lack early termination and liquidation rights and the non-defaulting party is exposed to the defaulting party under these other agreements. 16

17 Setoff rights under the NAESB are triggered following the occurrence of an Event of Default and the declaration of an early termination date. 96 The NAESB allows the parties to elect in the contract whether setoff rights will apply (i) only to obligations arising under the NAESB, (ii) to amounts payable by one party to the other under any other agreement or arrangement between the parties, or (iii) to any amount owed between the parties or their affiliates. 97 Regardless of the election made, the parties will at a minimum be permitted to setoff all amounts owing under the NAESB. 98 It is usually beneficial to the non-defaulting party to setoff as many mutual debts with the defaulting party as possible. Cross-product setoff allows the non-defaulting party to setoff obligations arising under different types of energy agreements and to minimize its payment 96 See NAESB Id. 98 The applicable provision when setoff under other agreements does not apply reads as follows: The Non- Defaulting Party shall net or aggregate, as appropriate, any and all amounts owing between the parties under Section , so that all such amounts are netted or aggregated to a single liquidated amount payable by one party to the other (the Net Settlement Amount ). At its sole option and without prior Notice to the Defaulting Party, the Non- Defaulting Party may setoff any Net Settlement Amount against any margin or other collateral held by it in connection with any Credit Support Obligation relating to the Contract. The applicable provision when bilateral setoff under other agreements applies reads as follows: The Non-Defaulting Party shall net or aggregate, as appropriate, any and all amounts owing between the parties under Section , so that all such amounts are netted or aggregated to a single liquidated amount payable by one party to the other (the Net Settlement Amount ). At its sole option and without prior Notice to the Defaulting Party, the Non-Defaulting Party is hereby authorized to setoff any Net Settlement Amount against (i) any margin or other collateral held by a party in connection with any Credit Support Obligation relating to the Contract; and (ii) any amount(s) (including any excess cash margin or excess cash collateral) owed or held by the party that is entitled to the Net Settlement Amount under any other agreement or arrangement between the parties. The applicable provision when triangular setoff applies reads as follows: The Non-Defaulting Party shall net or aggregate, as appropriate, any and all amounts owing between the parties under Section , so that all such amounts are netted or aggregated to a single liquidated amount payable by one party to the other (the Net Settlement Amount ). At its sole option, and without prior Notice to the Defaulting Party, the Non-Defaulting Party is hereby authorized to setoff (i) any Net Settlement Amount against any margin or other collateral held by a party in connection with any Credit Support Obligation relating to the Contract; (ii) any Net Settlement Amount against any amount(s) (including any excess cash margin or excess cash collateral) owed by or to a party under any other agreement or arrangement between the parties; (iii) any Net Settlement Amount owed to the Non-Defaulting Party against any amount(s) (including any excess cash margin or excess cash collateral) owed by the Non-Defaulting Party or its Affiliates to the Defaulting Party under any other agreement or arrangement; (iv) any Net Settlement Amount owed to the Defaulting Party against any amount(s) (including any excess cash margin or excess cash collateral) owed by the Defaulting Party to the Non-Defaulting Party or its Affiliates under any other agreement or arrangement; and/or (v) any Net Settlement Amount owed to the Defaulting Party against any amount(s) (including any excess cash margin or excess cash collateral) owed by the Defaulting Party or its Affiliates to the Non-Defaulting Party under any other agreement or arrangement. Id. 17

18 obligations on a portfolio-wide, rather than an agreement-by-agreement, basis. 99 Cross-affiliate setoff allows the parties to do the same but across all of the parties entities. In some cases, cross-product setoff involves setting off forward contracts against swap agreements. The parties ability to effect this setoff allows the parties to aggregate exposure across all the trading products with a counterparty, thereby permitting the flexible use of credit lines across products and the more efficient utilization of posted collateral. Although widely assumed to be enforceable in the energy industry, setting off forward contracts against swap agreements pursuant to the safe harbor provisions of the Bankruptcy Code was not explicitly permitted by statute until Section 561 was added as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of Section 561 not only permits the setoff of obligations arising under forward contracts against those arising under swap agreements, it also specifically permits such setoff under the terms of a master netting agreement. 100 III. Comparison of NAESB and Code Remedies A. NAESB Remedies Compared. Liquidated damages under Section 3.2 and early termination and liquidation under Section 10.3 differ in several material respects. First, the payment by the defaulting party of liquidated damages pursuant to Section 3.2 prevents an Event of Default under the agreement, and the affected transactions and the master agreement continue in full force and effect. 101 Industry participants typically treat liquidated damages as a routine occurrence, and the master agreement and any affected transactions continue despite the failure that caused the liquidated damages. 99 E.g., if two parties have entered into a NAESB for physical gas transactions and an ISDA for financial gas transactions, the non-defaulting party would setoff obligations under both agreements to arrive at a single net sum rather than confining the setoff to each agreement and creating separate payment obligations U.S.C.A. 561(a)-(b) (2005). 101 See NAESB

19 In contrast, early termination and liquidation rights under Section 10.3 arise when there has been an Event of Default, which are usually occurrences that have global implications on a party s ability to perform under the master agreement. 102 These occurrences typically relate to the credit, payment history, and/or solvency of the defaulting party or of a guarantor or affiliate of a party to a master agreement. The broad scope of Events of Default can cause their occurrence under one agreement to create early termination and liquidation rights under another agreement. 103 Likewise, an action or failure on the part of a guarantor or affiliate of a party to a master agreement can also constitute an Event of Default. Upon an Event of Default, early termination and liquidation provisions usually provide the non-defaulting party: (i) the right to terminate all outstanding transactions; (ii) the right to liquidate the terminated transactions; and (iii) the right to setoff amounts due under such transactions and, in some cases, across master agreements and across affiliates. The exercise of a party s rights under termination and liquidation provisions causes the cessation of, at a minimum, the terminated and liquidated transaction(s), and usually the entire master agreement and all transactions thereunder. Second, liquidated damages (calculated pursuant to the Cover or Spot Price standard under Section 3.2) are the exclusive remedy under all transactions for a failure to deliver or receive Gas. 104 Unlike the liquidated damages remedy for a failure to deliver or receive a commodity, one characteristic of early termination and liquidation provisions is that they typically are only one of several remedies for an Event of Default. Exclusive remedies usually are used in commodity contracts to avoid any risk of the imposition of damages other than actual direct damages, and to avoid any extraordinary equitable relief in recognition that the harm resulting from a failure to deliver or receive a commodity can be usually wholly remedied by liquidated damages. The non-exclusive nature of early termination and liquidation is based upon the premise that the occurrence of an Event of Default is such an extreme situation that the non-defaulting party should be given the greatest possible degree of latitude in mitigating and recovering its damages. 102 See NAESB 10.2 and E.g., a failure to pay under one contract can trigger an event of default under another contract. 104 See NAESB 3.2 (stating that payment of liquidated damages is the sole and exclusive remedy of the parties in the event of a breach of a Firm obligation to deliver or receive Gas ) 19