How does one determine the value of power contracts under early termination? Given the vagaries of the contracts themselves, the process is neither clear nor standard, and often results in protracted and costly litigation. In a previous article, we had assumed that termination already had occurred (“Mastering the Mastering Agreement,” May 2005). But there is an even more basic question: Did the counterparty have the right to terminate in the first place?
Several recent cases have highlighted that termination can be a tricky business and is definitely not as straight forward as it would seem. The cases in-volve not just the valuation of the terminated portfolio but the legality of the terminations themselves. Although the exact details of each case are different, they do share at least one thing in common: the circumstances of each firm prior to termination and the assurances offered factored into the litigations and were central to the disputes. Given the relevant contractual language, this is to be expected.
Whether the applicable contract is the Western Systems Power Pool Agreement (WSPPA), Master Power Purchase and Sale Agreement (MPPSA) or ISDA (International Swaps and Derivatives Association) Agreement, the language governing termination rights is often unclear and subject to interpretation, and relies heavily on the tenets of “good faith,” “discretion,” and “commercially reasonable” behavior.
Although the right to terminate following events such as a failure to pay is often well defined, what is less clear is the right to terminate due to concerns regarding a counterparty’s potential failure to pay. Conventionally, concerns regarding counterparty performance have been addressed by using various forms of adequate assurance. However, the success of adequate assurance as a credit risk-management tool is based upon two prerequisites:
a) Clear contractual definitions governing: a. request of adequate assurance; b. provision and form of adequate assurance; and c. acceptance of adequate assurance.
b) Both parties being committed to ensuring contract performance to expiration and standing ready and willing to do so.
Without a clear definition of suitable adequate assurance and rules governing its request and acceptance, any counterparties not committed to contract performance will attempt to game the system, resulting in adequate assurance becoming more a tool of termination as opposed to its conventional use as a tool of performance. Let’s examine each contract and see how complicated this can get.
The provisions in the WSPPA provide guidance regarding the use of adequate assurance to manage counterparty default risk. Sections 22.1 and 22.2 deal with events of default and remedies for events of default, respectively. Section 27 on “creditworthiness” describes the conditions under which a dissatisfied party (“first party”) may require additional security from their counterparty (“second party”) to protect against a potential default event and what forms that security can take. The WSPPA lists 5 well-defined reasons for requesting additional adequate assurances:
a) Failing to perform or defaulting under other contracts;
b) Exceeding credit or trading limits set out in confirmation or agreements;
c) Debt downgrades;
d) Other material adverse changes in financial condition; and
e) Substantial changes in market prices which materially and adversely impact ability to perform.
Also in section 27, the WSPP lists acceptable forms of adequate assistance:
a) posting of a letter of credit;
b) cash prepayment;
c) posting of other acceptable collateral or security by the second party;
d) a guarantee agreement executed by a creditworthy entity; and
e) some other mutually agreeable method of satisfying the first party.
All five reasons for requesting adequate assurance are triggered by the financial viability of the second party and are independent of the financial situation of the company requesting adequate assurance (first party). Tellingly, the WSPPA also states that although the first party may require the second party to provide a form of adequate assurance, the form is at the second party’s option.
Further, section 27 of the WSPPA outlines the behavior and principles to be followed when requesting and accepting adequate assurances. The first sentence of the section states, “Should a party’s creditworthiness, financial responsibility, or performance viability become unsatisfactory to the other party in such other party’s reasonably exercised discretion … [the dissatisfied party can request adequate assurances].” It goes on to state that the first party may require the second party to provide [adequate assurance], at the second party’s option “(but subject to the first party’s acceptance based upon reasonably exercised judgment.” Clear-ly, an assumption of reasonableness runs throughout the agreement).
The WSPPA provides guidance with respect to events permitting requests for assurances and also the form of adequate assurance. However, in allowing “some other mutually agreeable method of satisfying the first party” as a form of adequate assurance, it widens the definition of form and makes the provision more ambiguous.
Section 5.1 of the MPPSA, “event of default,” states that an “event of default shall mean, with respect to a party (a ‘defaulting party’), the occurrence of any of the following ... (e) the failure of such party to satisfy the creditworthiness/collateral requirements agreed to pursuant to article eight [of the cover sheet].” Article 8 provides for the nomination of amounts and forms of collateral, but it gives little guidance to the rules governing the request and acceptance of adequate assurances in ensuring contract performance.
In section 5(a)(iii) of the 2002 ISDA Master Agreement, “credit support default” is listed as an event of default, but little guidance is offered other than stating that any credit support document must be complied with, current and valid. Nevertheless, the user’s guide to the ISDA 2002 Master Agreement does provide further guidance. Chapter 5 of the user’s guide on the “adequate assurances provision” states that under certain circumstances, parties to the 2002 [ISDA] agreement may wish to consider the incorporation of an adequate assurances provision. It further states that “under an adequate assurances provision, when reasonable grounds for insecurity of performance are present, the insecure party may demand adequate assurances of performance from its counterparty.”
Regarding the rules for acceptance, Chapter 5 states that “if assurances … are not adequate (in the good faith and commercially reasonable opinion of the demanding party), the insecure party may invoke the early termination and close-out netting provisions of the relevant agreement.” Consequently, similar to the WSPPA, the request and acceptance of adequate assurances is dictated by good faith and commercially reasonable behavior, which as the user guide states, has its origins in article 2 of the Uniform Commercial Code.
The Uniform Commercial Code is the body of laws adopted by most states to help regulate the laws governing commercial transactions. Section 609 of Article 2 governing the “right to adequate assurance of performance” states “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.” It goes on to state that “(2) between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards.”
Again, we are left without explicit guidance. However, the requirement of commercial reasonableness again is present, and it is clear that the request and acceptance of adequate assurance should be in line with “commercial standards” or, in other words, standard-market practice.
Although this sounds vague and legalistic, the requirements that such standards impose should not be ignored. But what is standard market practice? What principles should govern the request and acceptance of adequate assurance?
An assessment of standard-market practice governing the request and acceptance of adequate assurances must start by truly understanding the sole function of adequate assurances. In plain English, they are a tool to maximize the probability that a contract entered into by two willing counterparties will run its due course. Consider the following chain of events that demonstrate the use of adequate assurance as a tool of contractual performance:
Example 1: Adequate assurance as a tool of performance
a) Second party is downgraded to sub-investment grade by the rating agencies;
b) First party requests adequate assurances to ensure performance of contract;
c) Second party offers assurances deemed sufficient to ensure performance;
d) First party accepts adequate assurance in good faith if it deems that such assurance is sufficient to ensure contract performance; and
e) Contract continues to expiration.
The first party entirely is within its contractual rights to request adequate assurance after the second party’s downgrade as its contract performance has been called into question. If the second party offers sufficient adequate assurance acceptable to the first party (assuming commercial reasonableness and good faith) then the contract is likely to perform and continue until expiration. However, in recent times a dangerous trend has become more pervasive whereby, ironically, adequate assurance—conventionally a tool to guarantee performance—has been used as a tool to ensure non-performance. Consider the following example:
Example 2: Adequate assurance as a tool of termination
a) First party is downgraded to sub-investment grade by the rating agencies;
b) First party looks to monetize in-the-money positions to enhance cashflow;
c) Second party is downgraded to sub-investment grade by the rating agencies;
d) First party requests adequate assurances to ensure performance of contract;
e) Second party offers assurances deemed sufficient to ensure performance; and
f) First party deems all offers of adequate assurance unacceptable and terminates the contract and demands settlement amount.
The above example is similar to example 1, with one important exception: There no longer are two willing parties to the contract. This is the key difference between adequate assurances being used to ensure performance and being used to ensure non-performance.
The first party now appears to have an internal and ulterior motive for contract termination; the party needs to improve its credit rating.
This has been widespread in the energy trading industry in the past few years, with companies triggering terminations either to accelerate cashflows from in-the-money positions or in some instances using it as a vehicle to expeditiously exit the business altogether (and signal to the rating agencies they have shelved their devilish trading businesses). Surely, however, these motives are not commercially reasonable or in good faith. Why should the financial viability of the first party be a motive for requesting and then not accepting adequate assurance? Is adequate assurance not a tool to ensure financial performance of the second party?
To ensure commercial reasonableness and good faith, it is imperative that at all times the financial health of the first party be kept totally independent of decisions involving the request and acceptance of adequate assurance. That is not to say, however, that if the first party has itself experienced a previous credit event it has relinquished its right to demand future adequate assurances from the second party. It is commonplace, especially in physical transactions, for a contractual relationship to continue with sub-investment grade counterparties if it ensures surety of supply and business continuation. The first party should not be held hostage to a second party default simply due to the fact it has its own credit issues. Again, the financial health of the first party should be independent of the request and acceptance of adequate assurance from the second party.
Adequate assurance is an invaluable credit protection method if well defined and used in a commercially reasonable manner. However, the absence of clear definitions coupled with the widespread desire for early termination in a credit-constrained power industry has created perverse incentives, whereby requests for adequate assurance increasingly have been used as a means to guarantee non-performance. This is contrary to standard market practice. The sole purpose of adequate assurance is to encourage performance and maximize the probability that a contract runs to expiration.
Assurances when offered must be reviewed in depth and not dismissed out of hand. Both parties must exercise good faith, discretion, and fair dealing in accepting or rejecting them. Failure to do so could be the road to litigation.