1 8 th Annual Gas & Power Institute September 10-11, 2009 ISDA and its Commodity Annexes: The New EEI or NAESB? Craig R. Enochs Craig R. Enochs [email protected]

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8th Annual Gas & Power Institute

September 10-11, 2009

ISDA and its Commodity Annexes:The New EEI or NAESB?

Craig R. Enochs

Craig R. Enochs [email protected]

Jackson Walker L.L.P.1401 McKinney, Suite 1900

Houston, Texas 77010(713) 752-4200 phone

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Are the ISDA Gas and Power Annexes becoming more widely-used than the NAESB and EEI?

Why use the ISDA Gas and Power Annexes instead of the NAESB and EEI?

What are the “gap risks” between the ISDA Gas and Power Annexes, the NAESB and the EEI?

Issues

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Use of the ISDA Commodity Annexes: A Growing Trend

ISDA originally intended for use with financial products Drafted by bankers and lawyers in New York and London

to standardize derivative transactions

In the last few years, the ISDA has gained popularity in the energy industry because of the publication of various commodity annexes Power Annex (2003), Gas Annex (2004), Emissions

Allowance Annex (2006), Coal Annex (2007), Crude Oil Annex (2008)

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ISDA Gas Annex and the NAESB Joint Effort:

After NAESB published in 2002, ISDA and NAESB worked together in creating the Gas Annex

Gas Annex published by ISDA in 2004

Similar Provisions: Gas Annex closely follows the NAESB’s provisions

relating to the purchase and sale of physical gas Clauses (b) through (g), (h) and (i) of the Gas Annex

are similar to Sections 3 through 8, 11 and 13 of the 2002 NAESB, respectively

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ISDA Power Annex and the EEI Joint Effort:

After EEI Master Agreement published in 2000, ISDA and EEI worked together in creating the Power Annex

Power Annex published by ISDA in 2003

Similar Provisions: Power Annex closely follows the EEI’s provisions

relating to the purchase and sale of physical power Clauses (b)-(c), (d)-(e), (f) and (g) of the Power

Annex are similar to Articles 3-4, 6-7, 9 and Sections 10.3-10.4 of the EEI Master Agreement, respectively

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Why Use the ISDA Instead of the NAESB or EEI?

Trade various energy commodities under a single agreement by using the ISDA Annexes Net credit exposures across transactions and

products Single agreement setoff rights in bankruptcy Payment netting across transactions and

products

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Why Use the ISDA Instead of the NAESB or EEI? (cont.)

Streamlines negotiation and documentation process Once ISDA Master Agreement and Schedule

are in place, fairly simple to added Gas and/or Power Annex.

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Sources of Gap Risk in ISDA, NAESB and EEI

Though similar to the NAESB and EEI, the Gas and Power Annexes (respectively) are not exclusive agreements

Annexes form only part of entire ISDA agreement

Contain only those provisions necessary to implement purchase/sale and delivery of gas and power

E.g., delivery/receipt, scheduling, title, force majeure

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Sources of Gap Risk in ISDA, NAESB and EEI (cont.)

ISDA Master Agreement, Schedule and Credit Support Annex (as applicable) govern all transactions under Gas and Power Annexes

Provisions not specifically related to physical commodities, but still applicable to gas and power transactions

E.g., events of default, termination and settlement, credit provisions, notices, confirmation procedures

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Sources of Gap Risk in ISDA, NAESB and EEI (cont.)

Common reasons for gap risk across trading agreements: ISDA, NAESB and/or EEI with same counterparty at the

same time E.g., ISDA for new transactions with Counterparty A, and NAESB/EEI for

existing transactions with Counterparty A

ISDA, NAESB and/or EEI with different counterparties at the same time

E.g., ISDA for all transactions with Counterparty A, and NAESB/EEI for all transactions with Counterparty B.

To mitigate gap risk, must be aware of differences across agreements.

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Gap Risks in the

NAESB, EEI and ISDA

A. Confirmation Procedures

B. Netting

C. Notices

D. Credit Obligations

E. Events of Default & Termination Event

F. Termination, Liquidation and Settlement

G. Setoff

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1. 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

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2. EEI § 2.3

Parties evidence a transaction by exchanging a written Confirmation

Seller provides Confirmation to Buyer (or if Seller fails to provide, then Buyer may send)

Similar to a written transaction procedure

Failure to send or return an executed Confirmation does not invalidate the oral transaction agreed-upon by the parties

Similar to oral transaction procedure under NAESB

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3. Gas and Power Annexes: ISDA Master § 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 Master Agreement, Gas Annex or Power Annex

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4. NAESB, EEI 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

Seller confirms in NAESB and EEI, but ISDA does not specify

Inconsistent Dispute Resolution Procedures NAESB v. EEI v. ISDA

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B. Netting

1. NAESB § 7.7

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

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B. Netting

2. EEI § 6.4

All payments owed by each party in a monthly billing period are netted into single amount

The party owing the greater amount makes a single payment to the other party

Netting applies across all transactions

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B. Netting

3. Gas and Power Annexes: ISDA Master § 2(c)

Netting generally limited to amounts due (i) on the same date; (ii) in the same currency; and (iii) in respect of the same Transaction

Often modified by the parties in the ISDA Schedule

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B. Netting

4. Risk Analysis

Inconsistent netting provisions across multiple agreements may create cash flow and operational risks

Incorrect calculations on invoices Incorrect payments to counterparty

Cross-Transactional Netting NAESB v. EEI v. ISDA

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C. Notices1. NAESB § 9.2

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

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C. Notices

2. 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

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C. Notices3. Gas and Power Annexes: ISDA Master § 12(a)

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

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C. Notices

3. Gas and Power Annexes: ISDA Master § 12(a) (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).

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C. Notices

4. 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

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C. Notices4. 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

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1. NAESB § 10.1

Either party can demand Adequate Assurance of Performance if it has “reasonable grounds for insecurity” regarding other party’s performance

“Reasonable grounds for insecurity” not defined in NAESB, except that it includes a “material change in creditworthiness”

Only credit provision in NAESB apart from any CSA incorporated into the Contract

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2. EEI §§ 8.1 and 8.2: Elected on Cover Sheet

Credit Assurances (8.1(b) and 8.2(b))

Can demand Performance Assurance upon “reasonable grounds” for believing that Party’s creditworthiness or performance is unsatisfactory

Collateral Threshold (8.1(c) and 8.2(c)) Threshold margining, similar to Collateral Annex

Downgrade Event (8.1(d) and 8.2(d))

Parties can demand Performance Assurance upon the occurrence of a “Downgrade Event”

Downgrade Event defined by the Parties on the Cover Sheet

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D. Credit Obligations3. ISDA Gas and Power Annexes:

No credit provisions in the Master Agreement or Commodity Annexes

Parties generally rely on threshold margining under the ISDA CSA

4. Risk Analysis: Inconsistent credit requirements across agreements

(e.g., Adequate Assurances under NAESB v. margining under ISDA)

Benefit of ISDA: netting of exposures across products to minimize collateral obligations

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E. Events of Default & Termination Events

1. 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

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1. 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

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2. 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

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2. 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

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3. 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 or EEI

May be useful in jurisdictions without U.S. Bankruptcy Code “safe harbor” provisions

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3. Automatic Early Termination under ISDA (cont.)

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

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4. Risk Analysis

Events of Default mitigate credit and payment risks with respect to the Defaulting Party

More ways to terminate under ISDA than under NAESB or EEI, 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 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

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F. Termination, Liquidation & Settlement

1. NAESB v. ISDA Gas Annex

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

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1. NAESB v. ISDA Gas Annex (cont.)

ISDA § 6(e): Market Quotation and Loss

Market Quotation: Value of Terminated Transactions based on quotations from Reference-

Market 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

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2. EEI v. ISDA Power Annex 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)

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3. 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

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G. Setoff1. NAESB v. ISDA Gas Annex

NAESB § 10.3.2: Election on Cover Sheet

Other Agreement Setoffs Apply: 2002 NAESB: Bilateral 2006 NAESB: Bilateral or Triangular, as elected by the parties

Other Agreement Setoffs Do Not Apply 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 bilateral setoff in 2002 NAESB

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G. Setoff2. 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

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G. Setoff3. 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

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Conclusion

ISDA is becoming more widely-used in energy commodity industry

Differences exist between ISDA Gas Annex, Power Annex, NAESB and EEI

May be difficult to make all agreements consistent

Important to prioritize issues and determine scope of transactions when deciding whether to use ISDA Commodity Annexes and/or the NAESB and EEI

Research paper Gap risk summaries located at Appendices 1 and 2

Craig R. Enochs

[email protected]

Jackson Walker L.L.P.

1401 McKinney, Suite 1900

Houston, Texas 77010

(713) 752-4200 phone

Documents

1 8 th Annual Gas & Power Institute September 10-11, 2009 ISDA and its Commodity Annexes: The New EEI or NAESB? Craig R. Enochs Craig R. Enochs [email protected]