Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

Mastering the Mastering Agreement

Special Series Part 5:  How to find "commercially reasonable" valuation in power contract terminations.

Fortnightly Magazine - May 2005

Contract termination should be easy. Consult the applicable master agreement, calculate the close-out amount, and send or receive a check. If only it were so. The well-publicized demise of key players in the energy industry has led to many counterparties failing to perform on their contractual obligations.

In the course of calculating settlement amounts, it has become apparent that many sections of the governing agreements, particularly those sections dealing with termination and settlement calculation, are maddeningly vague and unclear. Disputes and litigation have resulted, with many cases yet to be resolved.

Whereas the contractual language that defines an "event of default" is often clear (although even this seemingly straightforward topic can be subject to interpretation and dispute), the guidelines regarding the calculation of a "settlement amount" following an event of default often are not. The language within the majority of master agreements used in electricity trading remains murky and open to interpretation. Phrases such as "commercially reasonable valuation" or "settlement amount must be determined in good faith" are commonplace in electricity trading master agreements but are not clearly defined. In the absence of clear guidelines or standard industry practice, the settlement process often turns out to be litigious, protracted, and costly.

In this discussion, we investigate the guidance offered in the key electricity master agreements regarding the calculation of settlement amounts following an event of default and subsequent termination. We also illustrate what we perceive to be a "commercially reasonable" or "good faith" approach to determining settlement amounts.

Let's start by examining the three major contracts most common in power trading: the ISDA Master Agreement, the Western States Power Pool Agreement (WSPPA), and the Edison Electric Institute (EEI) Master Power Purchase and Sales Agreement (the EEI agreement).

Interpreting the ISDA Master Agreement

So what does all this contractual jargon mean from a financial perspective? Is there really any concrete guidance here to assist us in determining a commercially reasonable "close-out amount," or do we have to rely on our own interpretation of commercial reasonableness? As is usual with power contracts, the answer lies somewhere in the middle ( see sidebar, “A Reference: Reading The Fine Print,”  below).

First we are told to act in good faith and use commercially reasonable procedures, , behave in a fair, reasonable, truthful, and equitable manner. In fact, the Uniform Commercial Code (UCC) demands "honesty in fact and the observance of reasonable commercial standards of fair dealing." An assumption of good faith runs through all aspects of the ISDA as well as all other power contracts, from original execution, to the decision to terminate, to the determination of a fair and reasonable settlement amount. That should not be taken lightly; duplicitous or disingenuous behavior in negotiation, termination, and settlement is forbidden.

Second, the ISDA seems to provide for contract replacement over time if instantaneous replacement is deemed to be commercially

Pages