The University of Texas School of Law

Continuing Legal Education • 512-475-6700 • www.utcle.org

Presented:

7th Annual Gas & Power Institute

September 4-5, 2008

Houston, Texas

Managing “Gap Risk” Between Standard Form

Trading Agreements

Craig R. Enochs

Kevin M. Page

Jackson Walker L.L.P.

Jackson Walker L.L.P.

1401 McKinney Street, Suite 1900

Houston, Texas 77010

Craig R. Enochs

cenochs@jw.com

(713) 752-4315

Kevin M. Page

kpage@jw.com

(713) 752-4227

TABLE OF CONTENTS

I. 2002 NAESB Compared to 2006 NAESB................................................................................2

A. Section 3: Performance Obligation.....................................................................................2

1. Cover Standard and Spot Price Standard ......................................................................2

2. Ability to Cover All or a Portion of Gas ........................................................................2

3. Impact on Operation of Cover Standard ........................................................................3

B. Section 10: Financial Responsibility ..................................................................................3

1. Section 10.1: Adequate Assurance of Performance ......................................................3

2. Section 10.2: Events of Default .....................................................................................4

3. Section 10.3: Termination of Transactions Upon Event of Default ..............................5

4. Section 10.3.2: Other Agreement Setoffs.......................................................................6

C. Section 14: Market Disruption............................................................................................8

D. Section 15: Miscellaneous ..................................................................................................9

1. Section 15.12: Imaged Agreements ...............................................................................9

II. 2002 NAESB Compared to ISDA Gas Annex .......................................................................9

A. Confirmation Procedures .....................................................................................................9

B. Netting................................................................................................................................10

C. Notices ...............................................................................................................................11

D. Financial Responsibility ....................................................................................................13

E. Events of Default and Termination Events ........................................................................13

F. Termination and Liquidation of Gas Transactions.............................................................16

G. Setoff Rights ......................................................................................................................18

III. 2006 NAESB Compared to ISDA Gas Annex....................................................................19

A. Events of Default ...............................................................................................................19

IV. EEI Compared to ISDA Power Annex ...............................................................................20

A. Events of Default, Termination Events and Early Termination Date................................20

B. Notices ...............................................................................................................................21

C. Automatic Early Termination ............................................................................................22

D. Payments on Early Termination ........................................................................................23

E. Setoff ..................................................................................................................................24

V. 1992 ISDA Compared to 2002 ISDA ....................................................................................24

A. Payments on Early Termination ........................................................................................24

B. Events of Default ...............................................................................................................25

1. Cure Periods.................................................................................................................26

2. Breach of Agreement ....................................................................................................26

3. Default Under Specified Transaction...........................................................................26

4. Cross Default................................................................................................................28

5. Merger Without Assumption.........................................................................................28

6. Credit Support Default .................................................................................................28

C. Setoff..................................................................................................................................29

VI. CTA Compared to ISDA Coal Annex ................................................................................29

A. Confirmation Procedures ...................................................................................................29

B. Audit Rights .......................................................................................................................30

C. Events of Default ...............................................................................................................30

1. Failure to Pay...............................................................................................................31

2. Failure of Other Obligations........................................................................................31

3. Bankruptcy....................................................................................................................32

4. Material Adverse Change.............................................................................................33

5. Other Events of Default and Termination Events Under the ISDA..............................33

D. Setoff Rights ......................................................................................................................34

E. Waiver of Jury Trial ...........................................................................................................34

F. Transfer and Assignment....................................................................................................34

G. Notices ...............................................................................................................................35

H. Confidentiality ...................................................................................................................36

I. Severability and Survival of Rights...................................................................................37

J. Forward Contract ..............................................................................................................37

1

In the energy commodity industry, the term “master agreement” means an agreement

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, the EEI Master Power Purchase and Sale Agreement (the “EEI”)2 is commonly

used to document power transactions, the Coal Trading Association’s Master Coal Purchase and

Sale Agreement (the “CTA”)3 is commonly used to document coal transactions, and the ISDA

Master Agreement (“ISDA”) is commonly used to document derivative transactions. The ISDA

also is used to document Gas, power and coal transactions through the use of the Gas Annex, the

Power Annex and the Coal Annex.4

Parties may have NAESB, EEI, CTA and/or ISDA agreements, and multiple versions of

each, outstanding with the same counterparty at the same time. Minor differences between such

trading agreements could create risk for a party transacting under different agreements. Risk

also may arise when parties enter into different versions of the same trading agreement. Parties

can mitigate such risks by modifying the concepts contained in trading contracts to promote

consistency across agreements. However, parties first must be aware of the numerous trading

risks created by such differences.5 The purpose of this paper is to analyze differences between

the NAESB, EEI, ISDA and CTA (and between different versions thereof) that could create

trading risk due to inconsistent terms among such agreements.6

1 For purposes herein, (i) all citations and references to the “2002 NAESB” shall be to the version published by the

North American Energy Standards Board, Inc. on April 19, 2002; (ii) all citations and references to the “2006

NAESB” shall be to the version published by the North American Energy Standards Board, Inc. on September 5,

2006; and (iii) all citations and references to the “NAESB” shall be to both the 2002 NAESB and 2006 NAESB,

collectively. 2 For purposes herein, all citations and references to the “EEI” shall be to the version published by the Edison

Electric Institute and National Energy Marketers Association, version 2.1 (modified March 3, 2000). 3 For purposes herein, all citations and references to the “CTA” shall be to the 2006 Master Coal Purchase and Sale

Agreement approved and published by the Coal Trading Association in December, 2006. 4 For purposes herein, (i) all citations and references to the “ISDA Master Agreement” or the “1992 ISDA” shall be

to 1992 Master Agreement (Multicurrency-Cross Border) published by the International Swaps and Derivatives

Association, Inc. (“ISDA”); (ii) all citations and references to the “2002 ISDA” shall be to the 2002 Master

Agreement (Multicurrency-Cross Border) published by ISDA; (iii) all citations and references to the “ISDA

Schedule” shall be to the ISDA Schedule to the Master Agreement, which forms part of the ISDA Master

Agreement; (iv) all citations and references to the “ISDA CSA” shall be to the 1994 Credit Support Annex

published by ISDA; (v) all citations and references to the “Gas Annex” shall be to the ISDA North American Gas

Annex published by ISDA in 2004; (vi) all citations and references to the “Power Annex” shall be to the North

American Power Annex published by ISDA in 2003; (vii) all citations and references to the “Coal Annex” shall be

to the ISDA Global Physical Coal Annex published by ISDA on April 18, 2007; and (viii) all citations and

references to the “ISDA” shall be to the collective ISDA Agreement, including the ISDA Master Agreement

(whether the 1992 or 2002 form), the ISDA Schedule, the ISDA CSA, and any other Annexes or documents the

parties may elect to incorporate thereunder. 5 For example, to avoid gaps between various energy contracts, parties may wish to amend the terms of form trading

agreements by incorporating special provisions or additional elections that are consistent throughout such party’s

energy transactions.F 6 Though differences exist between the various credit documents associated with the NAESB, EEI, ISDA and CTA

(such as the NAESB’s Credit Support Addendum (the “NAESB CSA”), the EEI’s Collateral Annex, and the ISDA

CSA), an analysis of the distinctions between such credit documents is beyond the scope of this paper.

2

I. 2002 NAESB Compared to 2006 NAESB7

A. Section 3: Performance Obligation

1. Cover Standard and Spot Price Standard

Under the NAESB, the parties may elect either the “Cover Standard” or the “Spot Price

Standard” as the methodology used to calculate liquidated damages upon a party’s failure to

perform.8 Section 3.2 (Cover Standard) provides that if a party (the “Non-Performing Party”)

fails to deliver or receive Gas under a Firm obligation, the other party (the “Performing Party”) is

entitled to liquidated damages based on the positive difference between (i) the replacement price

for such Gas purchased by Buyer using the Cover Standard9 and the Contract Price (if Buyer is

the Performing Party); or (ii) the resale price for such Gas sold by Seller using the Cover

Standard and the Contract Price (if Seller is the Performing Party).10

If, after using commercially

reasonable efforts, the Non-Performing Party is unable to purchase replacement Gas or sell the

default Gas (and therefore cannot determine a replacement price or resale price necessary to

calculate liquidated damages under the Cover Standard), the NAESB provides that the Non-

Performing Party may recover damages based on the difference between the Contract Price and

the Spot Price.11

2. Ability to Cover All or a Portion of Gas

Though both the 2002 NAESB and the 2006 NAESB generally provide that the Spot

Price may be used in calculating liquidated damages if a replacement or resale price cannot be

calculated using the Cover Standard,12

the 2006 NAESB (unlike the 2002 NAESB) contains

language directly addressing situations when a Performing Party may be able to “cover” with

respect a portion—but not all—of the Contract Quantity of Gas in a Transaction. Section 3.2

7 For purposes of this Section I, all capitalized terms used herein but not otherwise defined herein shall have the

meanings set forth in the 2002 NAESB or 2006 NAESB, as applicable. 8 See NAESB § 3.2.

9 See 2002 NAESB § 2.10; 2006 NAESB § 2.12 (“ “Cover Standard”, as referred to in Section 3.2, 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 is elected by Buyer and replacement 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.”). 10

Id. 11

NAESB § 3.2 (Cover Standard); see also 2002 NAESB § 2.26; 2006 NAESB § 2.31 (“ “Spot Price” as referred to

in Section 3.2 shall mean the price listed in the publication indicated on the Base Contract, under the listing

applicable to the geographic location closest in proximity to the Delivery Point(s) for the relevant Day; provided, if

there is no single price published for such location for such Day, but there is published a range of prices, then the

Spot Price shall be the average of the following: (i) the price (determined as stated above) for the first Day for

which a price or range of prices is published that next precedes the relevant Day; and (ii) the price (determined as

stated above) for the first Day for which a price or range of prices is published that next follows the relevant Day.”). 12

NAESB § 3.2 (Cover Standard) subsection (iii).

3

(Cover Standard) subsection (iii) of the 2006 NAESB provides that if a Performing Party is

unable to calculate liquidated damages based on the Cover Standard because a replacement

purchase or sale is unavailable for all or any portion of Gas, then, in addition to any damages for

which a replacement purchase or sale of Gas is available, the Performing Party may recover

damages using the Spot Price for that portion of Gas not otherwise replaced or sold under the

Cover Standard.13

Section 3.2 (Cover Standard) subsection (iii) of the 2002 NAESB does not

provide such language regarding a Performing Party’s rights when only a portion of Gas is

unable to be purchased or sold under the Cover Standard.

3. Impact on Operation of Cover Standard

While Section 3.2 of the 2006 NAESB provides clarification not found in the 2002

NAESB, the practical effect of such additional language in the 2006 NAESB is minimal.

Though it does not contain language referencing the “portion of Gas not otherwise replaced or

sold” found in the 2006 NAESB, the 2002 NAESB still articulates that if a Performing Party is

unable to purchase or sell Gas in order to calculate damages under the Cover Standard, it may

use the Spot Price in making such calculation. The parties under the 2002 NAESB could imply

that such a remedy is available if the Performing Party is able to purchase or sell only a portion

of Gas under the Cover Standard—even without any express language contemplating this

situation. However, because the scope of the Cover Standard in the 2002 NAESB is not as

clearly-articulated as in the 2006 NAESB, parties may wish to modify the 2002 NAESB to

conform to language found in the 2006 NAESB in order to avoid the risk that a party’s remedies

may differ under the two forms of NAESB agreements.

B. Section 10: Financial Responsibility

1. Section 10.1: Adequate Assurance of Performance14

13

2006 NAESB § 3.2 (“The 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 quantify of such Gas not replaced or sold.” (emphasis added to show differences between

2002 and 2006 NAESB language). 14

While some parties rely solely on Section 10.1 of the NAESB for protection in mitigating counterparty credit risk,

other parties may elect to incorporate the NAESB CSA as part of the Contract. The NAESB CSA provides many of

the same protections found in the ISDA CSA, such as threshold margining based on a party’s exposure under a

4

Section 10.1 of both the 2002 NAESB and 2006 NAESB allows a party (the “Demanding

Party”) to demand Adequate Assurance of Performance when the other party (the “Pledging

Party”) has reasonable grounds for insecurity regarding the performance of any obligation under

the Contract. Adequate Assurance of Performance can take the form of, but is not limited to,

cash, a standby irrevocable letter of credit, prepayment or a security interest in an asset or

guaranty.15

With respect to Adequate Assurance of Performance provided in the form of cash,

the 2006 NAESB expressly grants to the Demanding Party a first priority security interest in, lien

on, and right of setoff against any such cash.16

This interest and lien are released when the

Demanding Party returns such Adequate Assurance of Performance to the Pledging Party.17

By expressly granting a first priority interest in and lien on cash received and held by the

Demanding Party, the 2006 NAESB offers protection to the Demanding Party in the event that

the Pledging Party’s creditors claim rights to such cash in order to satisfy the Pledging Party’s

debts. The 2002 NAESB does not contain a similar provision expressly protecting the

Demanding Party from the Pledging Party’s creditor claims.

2. Section 10.2: Events of Default

Section 10.2 of the NAESB sets forth certain events which give rise to an Event of

Default under the NAESB if committed by a party or its Guarantor,18

such as filing a petition for

bankruptcy19

and failing to perform any Credit Support Obligations under the NAESB.20

The

2006 NAESB also incorporates “Additional Events of Default”21

which expressly include

“Transactional Cross Default” and “Indebtedness Cross Default,” each as may be elected by the

parties on the NAESB Cover Sheet.22

transaction. However, an in-depth analysis of the NAESB CSA and the ISDA CSA is beyond the scope of this

paper. 15

NAESB § 10.1. It should be noted that Section 10.1 of the 2002 NAESB, unlike the 2006 NAESB, does not

expressly include “cash” as a form of Adequate Assurance of Performance. However, the list of examples of

Adequate Assurance of Performance is non-exhaustive, and cash commonly is contemplated as a form of Adequate

Assurance of Performance between parties. 16

2006 NAESB § 10.1 (“Y hereby grants to X a continuing first priority security interest, in, lien on, an right of

setoff against all Adequate Assurance of Performance in the form of cash transferred by Y to X pursuant to this

Section 10.1. Upon the return by X to Y of such Adequate Assurance of Performance, the security interest and lien

granted hereunder on that Adequate Assurance of Performance shall be released automatically and, to the extent

possible, without any further action by either party.” 17

Id. 18

The term “Guarantor” is undefined in the 2002 NAESB and is defined in the 2006 NAESB as “any entity that has

provided a guaranty of the obligations of a party hereunder.” 2006 NAESB § 2.21. 19

NAESB § 10.2, subsection (ii). 20

NAESB § 10.2, subsection (vi). 21

2006 NAESB § 10.2, subsection (ix). 22

2006 NAESB § 2.1 (“ “Additional Event of Default” shall mean Transactional Cross Default or Indebtedness

Cross Default, each as and if selected by the parties pursuant to the Base Contract.”).

5

If Transactional Cross Default applies to a party, then it will constitute an Event of

Default under the NAESB if such party defaults under any Specified Transaction.23

The term

“Specified Transaction” means any other transaction or agreement between the parties for the

purchase, sale or exchange of Gas, and any other transaction or agreement specified by the

parties on the NAESB Cover Sheet.24

By electing Transactional Cross Default, a party can

ensure that if the other party defaults on Gas transactions or agreements (or any other

agreement(s) specified by the parties on the Cover Sheet), it shall constitute an Event of Default

under the NAESB. This protects a party from performance risk while still allowing it to

document transactions in separate NAESB agreements.25

If Indebtedness Cross Default applies to a party, then it shall be an Event of Default

under the NAESB if (i) such party or its Guarantor experiences a default under one or more

agreements or instruments relating to indebtedness for the payment or repayment of borrowed

money, and the default results in such indebtedness becoming immediately due and payable; and

(ii) the amount of such default, in the aggregate, is greater than such party’s (or its Guarantor’s)

threshold specified in the NAESB Cover Sheet.26

Both Transactional Cross Default and Indebtedness Cross Default may be useful to

parties in evaluating a counterparty’s commercial and credit risk, as both events look to a

counterparty’s performance outside the NAESB (whether in Gas agreements or agreements

relating to indebtedness) as indicators in determining an Event of Default under the NAESB.

3. Section 10.3: Termination of Transactions Upon Event of Default

Section 10.3 of the NAESB generally provides that if an Event of Default has occurred

and is continuing, the Non-Defaulting Party may declare an Early Termination Date, a date on

which all transactions under the NAESB will terminate. On the Early Termination Date, all

transactions must be terminated and liquidated, except for certain types of transactions expressly

excluded by the NAESB (such transactions being “Excluded Transactions”).27

The following

transactions are considered Excluded Transactions under the 2002 NAESB: (i) transactions that

may not be terminated and liquidated under applicable law; or (ii) transactions that are, in the

23

2006 NAESB § 2.33 (“ “Transactional Cross Default” shall mean if selected on the Base Contract by the parties

with respect to a party, that it shall be in default, however therein defined, under an Specified Transaction.”). 24

2006 NAESB § 2.30 (“ “Specified Transaction(s)” shall mean any other transaction or agreement between the

parties for the purchase, sale or exchange of physical Gas, and any other transaction or agreement identified as a

Specified Transaction under the Base Contract.”). 25

E.g., a party may wish to document a structured transaction using a NAESB separate from that used to document

routine trading transactions with a counterparty, but still terminate each NAESB if such counterparty defaults under

the relevant NAESB. 26

2006 NAESB § 2.23 (“ “Indebtedness Cross Default” shall mean if selected on the Base Contract by the parties

with respect to a party, that it or its Guarantor, if any, experiences a default, or similar condition or event however

therein defined, under one or more agreements or instruments, individually or collectively, relating to indebtedness

(such indebtedness to include any obligation whether present or future, contingent or otherwise, as principal or

surety or otherwise) for the payment or repayment of borrowed money in an aggregate amount greater than the

threshold specified in the Base Contract with respect to such party or its Guarantor, if any, which results in such

indebtedness becoming immediately due and payable.”). 27

NAESB § 10.3.

6

reasonable opinion of the Non-Defaulting Party, commercially impracticable to terminate and

liquidate.28

Excluded Transactions under the 2006 NAESB, however, consist of only those

transactions that may not be terminated or liquidated under applicable law.29

Thus, under the

2006 NAESB, a Non-Defaulting Party has no discretion in determining whether or not a

transaction is commercially impracticable to terminate upon the Early Termination Date. All

transactions under the 2006 NAESB—even if difficult to unwind because of their commercial

structure—must terminate on the Early Termination Date unless the law otherwise prevents such

termination and liquidation.

This restriction under the 2006 NAESB creates risk that, from a practical standpoint, a

party may not be able to terminate and liquidate certain types of Gas transactions by an Early

Termination Date. For example, Buyers purchasing Gas at illiquid Delivery Points may not be

able to readily determine the value of affected Gas transactions at such Delivery Points because

replacement Gas is otherwise unavailable. To avoid such risk, parties operating under the 2006

NAESB may wish to modify the agreement to specify that Excluded Transactions also may

encompass those transactions determined by the Non-Defaulting Party which are commercially

impracticable to terminate by the Early Termination Date.

4. Section 10.3.2: Other Agreement Setoffs

Upon terminating and liquidating NAESB transactions as of the Early Termination Date,

the Non-Defaulting Party calculates all amounts owed between the parties and aggregates such

amounts into a single payment owed by one party to the other party (the “Net Settlement

Amount”).30

Both the 2002 NAESB and the 2006 NAESB allow the parties to elect whether the

Non-Defaulting Party may setoff any Net Settlement Amount against other amounts.31

If the parties elect for “Other Agreement Setoffs” to apply under the 2002 NAESB, the

Non-Defaulting Party may setoff any Net Settlement Amount owed to the Non-Defaulting Party

against (i) any margin or collateral held by a party in connection with any Credit Support

Obligation32

relating to the contract, or (ii) any amount(s) payable by the Non-Defaulting Party

to the Defaulting Party under any other agreement.33

28

2002 NAESB § 10.3. 29

2006 NAESB § 10.3. 30

NAESB § 10.3.2. 31

Id. 32

2002 NAESB § 2.11 (“Credit Support Obligation(s)” means “any obligation(s) to provide or establish credit

support for, or on behalf of, a party to this Contract such as an irrevocable letter of credit, a margin agreement, a

prepayment, a security interest in an asset, a performance bond, guaranty, or other good and sufficient security of a

continuing nature.”). The 2006 NAESB definition in § 2.13 is identical to the 2002 definition, except the 2006

definition expressly includes “cash” and excludes “a performance bond” in describing the various forms of credit

support. 33

2002 NAESB § 10.3.2.

7

If “Other Agreement Setoffs” applies under the 2006 NAESB, the parties must elect

either a “Bilateral Setoff Option” or a “Triangular Setoff Option”.34

The Bilateral Setoff Option

is substantively similar to Section 10.3.2 of the 2002 NAESB.35

The Triangular Setoff Option—

specific only to the 2006 NAESB—allows the Non-Defaulting Party 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 Affiliates36

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 excess cash margin or excess cash collateral) owed by the

Defaulting Party to the Non-Defaulting Party or it 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. 37

The scope of triangular setoff under the 2006 NAESB is quite broad, anticipating that the Non-

Defaulting Party may setoff any Net Settlement Amount against other amounts (i) owed by or to

the Defaulting Party or its Affiliates; or (ii) owed by or to the Non-Defaulting Party or its

Affiliates.38

Such setoff rights available under the 2006 NAESB may be advantageous to parties

in terminating and liquidating transactions across multiple agreements between the parties or

their Affiliates.

34

2006 NAESB § 10.3.2. 35

Compare 2006 NAESB § 10.3.2 (Other Agreement Setoffs Apply, Bilateral Setoff Option) to 2002 NAESB §

10.3.2 (Other Agreement Setoffs Apply). 36

2006 NAESB § 2.2 (“ “Affiliate” shall mean, in relation to any person, any entity controlled, directly or indirectly,

by the person, any entity that controls, directly or indirectly, the person or any entity directly or indirectly under

common control with the person. For this purpose, “control” of any entity or person means ownership of at least 50

percent of the voting power of the entity or person.”). 37

2006 NAESB § 10.3.2 (Other Agreement Setoffs Apply, Triangular Setoff Option). 38

Id.

8

Setoff is an important tool in mitigating a party’s risk. With respect to obligations that

are setoff, (i) it immediately extinguishes such obligations between the parties; (ii) it eliminates

the Non-Defaulting Party’s credit risk for amounts owed by the Defaulting Party to the extent

such obligations are setoff; (iii) it eliminates the Non-Defaulting Party’s cash flow risk that

would otherwise be present while waiting for payments; and (iv) if the Defaulting Party is

bankrupt, it allows the Non-Defaulting Party to reduce its involvement in bankruptcy

proceedings and minimizes any payments the Non-Defaulting Party must make to the bankrupt

counterparty.39

Moreover, triangular setoff becomes particularly important in managing

commercial and credit risks on an enterprise-wide basis when parties and their related Affiliates

enter into multiple trading agreements.40

Because cross-transactional setoff and cross-Affiliate

setoff affect multiple agreements and entities, a party may wish to incorporate such setoff rights

in at least one (1) of its trading agreements to ensure that setoff may be applied across all of such

party’s (and its Affiliates’) applicable contracts.

C. Section 14: Market Disruption

The 2006 NAESB contains a provision that sets forth how the parties will determine a

replacement price for the Floating Price in the event a Market Disruption Event occurs.41

The

section requires that, upon the occurrence of a Market Disruption Event, the parties shall first

negotiate in good faith to determine the replacement price of Gas.42

If the parties cannot agree

upon a replacement price of Gas for an affected Day, then the parties must each obtain two (2)

price quotes based on Gas of a similar quantity, quality and geographical location near the

Delivery Point(s).43

The parties then will average the four (4) quotes together to determine the

replacement price for the Floating Price on the Day affected by the Market Disruption Event.44

The Market Disruption provision benefits parties because (i) it provides a set method of

determining a replacement price for Gas when the Floating Price is unavailable because of a

Market Disruption Event, thus removing the risk that parties rely on pre-litigation measures to

determine a replacement price instead of agreed-upon procedures; and (ii) it conforms the 2006

NAESB to similar language found in the ISDA.45

39

See Craig R. Enochs & Merida de la Pena, “Netting and Offset Principles in Energy Transactions”, State Bar of

Texas 24th

Annual Advanced Oil Gas & Energy Resources Law Course, October 5-6, Houston, Texas, Chapter 9, at

2-4. 40

Id. 41

2006 NAESB § 14 (“Floating Price” means “the price or a factor of the price agreed to in the transaction as being

based upon a specified index.”); (“Market Disruption Event” means, “with respect to an index specified for a

transaction, any of the following events: (a) the failure of the index to announce or publish information necessary for

determining the Floating Price; (b) the failure of trading to commence or the permanent discontinuation or material

suspension of trading on the exchange or market acting as the index; (c) the temporary or permanent discontinuance

or unavailability of the index; (d) the temporary or permanent closing of any exchange acting as the index; or (e)

both parties agree that a material change in the formula for or the method for determining the Floating Price has

occurred.”). 42

Id. 43

Id. 44

Id. 45

Compare 2006 NAESB § 14 to ISDA 2005 Commodity Definitions § 7.4.

9

D. Section 15: Miscellaneous46

1. Section 15.12: Imaged Agreements

The 2006 NAESB contains a clause not found in the 2002 NAESB concerning the

admissibility of NAESB documents that have been digitally copied, photocopied, or stored on

computers tapes and disks (the “Imaged Agreement”).47

Generally, Section 15.12 of the 2006

NAESB provides that Imaged Agreements are admissible into evidence in any judicial,

arbitration, mediation or administrative proceedings to the extent and under the same conditions

as business records originated and maintained in documentary form.48

The provision also

expressly provides that parties cannot object to the introduction of Imaged Agreements on the

grounds that such documents are not originated or maintained in documentary form. Such

waiver is an especially important benefit to NAESB parties who scan and save all documentation

electronically instead of maintaining paper files, as the Federal Rules of Evidence and similar

state evidentiary rules generally require an original document to be admitted into evidence

pursuant to the Best Evidence Rule.49

II. 2002 NAESB Compared to ISDA Gas Annex50

A. Confirmation Procedures

The 2002 NAESB allows the parties to elect on the Cover Sheet whether a Gas

transaction shall be formed through an “Oral Transaction Procedure” or a “Written Transaction

Procedure.”51

The Oral Transaction Procedure provides that a transaction is formed and the

parties are legally bound when the parties agree to a transaction’s commercial terms by telephone

or electronic data interchange transmission.52

Such oral agreement is considered a “writing” and

deemed to be “signed” by the parties.53

Though the NAESB requires that the Confirming Party

46

It should be noted that the “Miscellaneous” provisions in the 2002 NAESB are located in Section 14, and the

“Miscellaneous” provisions in the 2006 NAESB are located in Section 15. 47

2006 NAESB § 15.12 (“Any original executed Base Contract, Transaction Confirmation or other related

document may be digitally copied, photocopied, or stored on computer tapes and disks (the “Imaged Agreement”).

The Imaged Agreement, if introduced as evidence on paper, the Transaction Confirmation, if introduced as evidence

in automated facsimile form, the recording, if introduced as evidence in its original form, and all computer records

of the foregoing, if introduced as evidence in the printed format, in any judicial, arbitration, mediation or

administrative proceedings will be admissible as between the parties to the same extent and under the same

conditions as other business records originated and maintained in documentary form. Neither party shall object to

the admissibility of the recording, the Transaction Confirmation, or the Imaged Agreement on the basis that such

were not originated in documentary form. However, nothing herein shall be construed as a waiver of any other

objection to the admissibility of such evidence.”). 48

Id. 49

See, e.g., Fed. R. Evid. § 1002; Tex. R. Evid. § 1002. 50

For purposes of this Section II, any capitalized terms used herein but not otherwise defined herein shall have the

meanings set forth in the 2002 NAESB or the Gas Annex, as applicable. 51

2002 NAESB § 1.2. 52

2002 NAESB § 1.2 (Oral Transaction Procedure). 53

Id.

10

(as designated in the Cover Sheet) send a Transaction Confirmation to the other party reflecting

such commercial terms, the failure to send a Transaction Confirmation does not affect the

parties’ obligations to perform under the Contract.54

Alternatively, the Written Transaction Procedure requires that the parties exchange non-

conflicting written Transaction Confirmations before a transaction is formed and the parties are

legally obligated to perform under the NAESB.55

If a Transaction Confirmation sent by the Confirming Party is materially different from

the receiving party’s understanding of any transaction terms, the receiving party must notify the

Confirming Party by the Confirm Deadline (as designated by the parties on the Cover Sheet) or

the Transaction Confirmation will be deemed to reflect the binding agreement of the parties.56

To facilitate the formation of a transaction by either the Oral or Written Transaction

Procedure, Section 1.4 of the 2002 NAESB includes a stipulation that either party may

electronically record all telephone conversations between the parties with respect to any NAESB

transaction without further notice to the other party.57

Similar to the NAESB, the ISDA contemplates that the parties shall be legally bound by

the terms of each Transaction from the moment they agree to commercial terms (whether orally

or otherwise), and shall confirm Transactions in writing as soon as reasonably practicable

through the use of Confirmations.58

However, the specific details concerning the formation of

Transactions and the exchange of Confirmations clearly articulated under the NAESB are not

similarly incorporated into the ISDA Master Agreement or Gas Annex. Accordingly, many

parties often negotiate and incorporate Confirmation terms and procedures into the ISDA

Schedule similar to Confirmation terms and procedures found under the NAESB.

In determining whether to incorporate an oral or written transaction procedure in its

energy trading agreements, a party may wish to consider whether the applicable transaction (or

the relationship with the counterparty) is short-term or long-term. Oral transaction procedures

under the NAESB may be more desirable to a party in the context of a short-term transaction

where speed in forming a deal is paramount. This may be particularly useful to parties when

confronted with the risk that a transaction’s commercial terms are volatile. On the other hand, a

written transaction procedure requires the parties to clearly articulate and agree on the

commercial terms of a transaction before becoming legally bound to perform, thus minimizing

the risk that parties disagree on future performance obligations under a transaction.

B. Netting

54

Id. 55

2002 NAESB § 1.2 (Written Transaction Procedure). 56

2002 NAESB §1.3. 57

NAESB §1.4. 58

ISDA Master Agreement § 9.2(e)(ii); see recitals to ISDA Master Agreement, defining “Confirmation” as

“documents and other confirming evidence exchanged between the parties confirming [ISDA] Transactions.”

11

Section 7.7 of the 2002 NAESB provides that all payments due and owing (and/or past

due) between the parties under the Contract shall be netted into a single amount, such that the

party owing the greater amount shall make a single payment of the net amount owed to the other

party as and when required under the NAESB. Notably, the NAESB does not limit netting to

amounts owed under a single transaction between the parties.

In contrast, Section 2(c) of the ISDA Master Agreement expressly limits netting to

amounts (i) due on the same date; (ii) due in the same currency; and (iii) due in respect of the

same Transaction. However, the ISDA clearly anticipates that the parties may wish to modify

such default netting provision through the ISDA Schedule or a Confirmation, stating that the

parties can elect to net amounts owed with respect to all amounts payable on the same date in the

same currency with respect to two or more Transactions.59

If trading under multiple agreements,

a party may wish to ensure that all of its trading contracts contain consistent netting provisions,

thus minimizing the operational risk that payments under any agreement are incorrectly

calculated or delivered to the counterparty.60

C. Notices

Section 9 of the 2002 NAESB concerns the manner of providing Notices and the dates on

which such Notices are deemed delivered by a party. Section 9.2 states that Notices may be sent

by “facsimile or mutually acceptable electronic means, a nationally recognized overnight courier

service, first class mail or hand delivered.” Section 9.3 generally provides that Notices are

deemed delivered when received on a Business Day by the addressee. However, if proof of

actual receipt is not available, Notices are expressly subject to the following presumptions:

(i) Notice by facsimile shall be deemed to have been received upon the

sending party’s receipt of its facsimile machine’s confirmation of successful

transmission. If a facsimile is received after 5:00 p.m. on a Business Day or is

not otherwise received on a Business Day, the date of receipt shall be the next

following Business Day;

(ii) Notice by overnight mail or courier shall be deemed to have been received

on the next following Business Day after such Notice was sent, or earlier as

confirmed by the receiving party; and

(iii) Notice by first class mail shall be deemed to have been delivered five (5)

Business Days after mailing.61

The dates that Notices are deemed to be delivered and received becomes important under the

operation of the NAESB, as the sending of Notices may directly impact the timing of Events of

Default and designation of an Early Termination Date under the Contract. Timing requirements

59

ISDA Master Agreement § 2(c). 60

E.g., if a party is consistently netting across transactions with a counterparty under a NAESB, it may create

operational risk if such party is not permitted to net across all transactions with the same counterparty under an

ISDA. 61

2002 NAESB § 9.3.

12

or other administrative procedures regarding Notices increase the risk that a Non-Defaulting

Party may not be able to exercise its early termination rights as quickly as desired, thus

potentially increasing the Non-Defaulting Party’s market and credit risk to the Defaulting Party.

Though the Gas Annex does not contain express provisions concerning the manner,

method and delivery of notice with respect to Gas Transactions as in the NAESB, the ISDA

Master Agreement contains notice provisions affecting all ISDA Transactions—including those

for the purchase and sale of Gas. Section 12(a) of the ISDA Master Agreement provides that any

notice under the ISDA may be provided by the following relevant methods and shall be deemed

delivered as follows:

(i) Notices in writing and delivered by person or courier shall be effective on

the date it is delivered;

(ii) Notices sent by facsimile transmission shall be effective on the date such

transmission is received by a responsible employee of the recipient in legible form.

The burden of proving receipt shall be on the sender, and receipt cannot be

conclusively shown through a transmission report generated by the sender’s

facsimile machine;

(iii) Notices sent by certified or registered mail or the equivalent (return receipt

requested) shall be deemed delivered on the date such mail is delivered or its

delivery is attempted; and

(iv) Notices sent by electronic messaging system shall be deemed delivered on

the date such electronic message is received.62

In addition to the above, the 2002 ISDA also contemplates that notices sent by e-mail shall be

deemed effective on the date delivered.63

The above-stated notice provisions differ from the NAESB’s requirements, particularly

with respect to the dates in which notices by facsimile are deemed delivered and received.64

Moreover, unlike the NAESB, the ISDA clarifies that any notices or other communications sent

with respect to Events of Default (under Section 5 of the ISDA Master Agreement) or

termination of the Agreement (under Section 6 of the ISDA Master Agreement) may not be

provided by facsimile, electronic messaging system or e-mail.65

As a result, parties should be

cognizant of the need to potentially deliver different types of notices under various trading

agreements, even if such notices relate to the same counterparty and the same Event of Default.

62

ISDA Master Agreement § 12(a). 63

2002 ISDA § 12(a)(vi). 64

E.g., the ISDA squarely places the burden of proving receipt of a facsimile upon the sending party, but expressly

provides that a facsimile confirmation does not meet such burden. ISDA Master Agreement § 12(a)(iii). The

NAESB directly contradicts such ISDA provision, stating that notice by facsimile shall be deemed to be received

when the sending party receives a facsimile confirmation from its machine. 2002 NAESB § 9.3. 65

1992 ISDA § 12(a) (preventing such notices by “facsimile or electronic messaging system”); 2002 ISDA § 12(a)

(preventing such notices by “electronic messaging system or e-mail”).

13

To avoid the operational risk that the timing, manner or method of a party’s notice is ineffective

or insufficient under a relevant agreement, parties may wish to ensure that its trading contracts

contain consistent notice provisions.

D. Financial Responsibility

The 2002 NAESB allows either party to demand Adequate Assurance of Performance if

at any time such party has reasonable grounds for insecurity regarding the performance of the

other party’s obligations under the contract, whether or not such obligations are then due.66

Importantly, the NAESB does not define what constitutes “reasonable grounds for insecurity”

other than stating that such phrase includes “a material change in the creditworthiness” of the

other party.67

The Adequate Assurance of Performance concept in Section 10.1 of the 2002

NAESB is the only provision expressly providing credit security to the parties, apart from any

NAESB CSA the parties may elect to incorporate into the Contract.

The ISDA Gas Annex has no provision allowing for Adequate Assurance of Performance

or other form of credit protection, thus creating potential credit and settlement risk under a

Transaction. To avoid such risks, parties to the ISDA often enter into a Gas Annex in

conjunction with an ISDA CSA. Although the ISDA CSA does not contain an Adequate

Assurance of Performance provision similar to the 2002 NAESB, it does contain other forms of

credit protection such as threshold margining.68

E. Events of Default and Termination Events

Both the 2002 NAESB and the Gas Annex (in conjunction with the ISDA Master

Agreement) generally provide that a party may terminate and liquidate outstanding Gas

transactions upon the occurrence and continuation of an Event of Default.69

However, because

the structure of the Gas Annex differs from the structure of the NAESB, the specific acts

constituting Events of Default under each agreement differ as well. For example, the Gas Annex

does not contain any Events of Default, but instead generally relies on the Events of Default

specified in the ISDA Master Agreement. Because the ISDA Master Agreement is intended to

provide a framework facilitating various types of transactions (e.g., both physical and financial

deals with respect to any number of commodities), the Events of Default and Termination Events

set forth under the ISDA Master Agreement (which apply to Transactions under the Gas Annex)

are much broader in scope than the Events of Default provided in the 2002 NAESB.70

The 2002 NAESB contains Events of Default relating to bankruptcy and insolvency, as

well as a party’s failure to make payments under the Contract or any Credit Support Obligation.71

66

2002 NAESB § 10.1. For a full discussion of Adequate Assurance of Performance under the NAESB, see supra

at Section I(B)(1) herein. 67

Id. 68

See, e.g., ISDA CSA, Paragraph 3. 69

2002 NAESB § 10.3; ISDA Master Agreement § 6(a). 70

Compare ISDA Master Agreement §§ 5(a) and (b) to 2002 NAESB § 10.2. 71

2002 NAESB §§ 10.2(i) – (vi) and (viii).

14

Similarly, Section 5(a) of the ISDA Master Agreement contains Events of Default relating to a

party’s failure to pay, the breach of obligations under Credit Support Documents, and

bankruptcy-related events indicating a party’s insolvency.72

However, unlike the 2002 NAESB,

the ISDA contains other Events of Default which may be implicated in Transactions entered into

under the Gas Annex, such as (i) breaches of the Agreement (other than a failure to pay)

(“Breach of Agreement”);73

(ii) misrepresentations concerning the Agreement or any Credit

Support Document (“Misrepresentation”);74

(iii) defaults by a party, its Credit Support Provider

or any Specified Entity of the party with respect to any Specified Transaction (such as rates,

swaps, options, or other Transactions designated by the parties) (“Default Under Specified

Transaction”);75

(iv) defaults by a party or its Credit Support Provider with respect to agreements

or instruments relating to Specified Indebtedness (such as bank debt or other forms of debt

specified by the parties) (“Cross Default”);76

and (v) situations where a party or its Credit

72

ISDA Master Agreement §§ 5(a)(i), (iii) and (vii). Notably, with respect to a party’s filing of bankruptcy, the

ISDA incorporates a 30-day waiting period not otherwise found in the NAESB, such that an ISDA Event of Default

will not occur after a bankruptcy petition is filed by or against a party if the petition is dismissed within thirty (30)

days after instituted. 73

ISDA Master Agreement § 5(a)(ii) (“Failure by the party to comply with or perform any agreement or obligation

(other than an obligation to make any payment under this Agreement or delivery under Section 2(a)(i) or 2(e) or to

give notice of a Termination Event or any agreement or obligation under Section 4(a)(i), 4(a)(iii) or 4(d)) to be

complied with or performed by the party in accordance with this Agreement if such failure is not remedied on or

before the thirtieth day after notice of such failure is given to the party”). Notably, clause (j)(ii) of the Gas Annex

amends the Event of Default under § 5(a)(ii) to exclude any failure to deliver or receive Gas, as a party’s exclusive

remedy for failure to deliver or receive Gas is liquidated damages pursuant to clause (b)(ii) of the Gas Annex. 74

ISDA Master Agreement § 5(a)(iv) (“A representation (other than a representation under Section 3(e) or (f)) made

or repeated or deemed to have been made or repeated by the party or any Credit Support Provider of such party in

this Agreement or any Credit Support Document proves to have been incorrect or misleading in any material respect

when made or repeated or deemed to have been made or repeated”). 75

ISDA Master Agreement § 5(a)(v) (“The party, any Credit Support Provider of such party or any applicable

Specified Entity of such party (1) defaults under a Specified Transaction and, after giving effect to any applicable

notice requirement or grace period, there occurs a liquidation of, an acceleration of obligations under, or an early

termination of, that Specified Transaction, (2) defaults, after giving effect to any applicable notice requirement or

grace period, in making any payment or delivery due on the last payment, delivery or exchange date of, or any

payment on early termination of, a Specified Transaction (or such default continues for at least three Local Business

Days if there is no applicable notice requirement or grace period) or (3) disaffirms, disclaims, repudiates or rejects,

in whole or in part, a Specified Transaction (or such action is taken by any person or entity appointed or empowered

to operate it or act on its behalf).”). It should be noted that although the 2002 NAESB does not incorporate an Event

of Default similar to Default Under Specified Transaction under the ISDA, the 2006 NAESB does include such

Event of Default if elected by the parties (termed a “Transactional Cross Default”) as a NAESB “Additional Event

of Default”. See discussion supra at Section I(B)(2). 76

ISDA Master Agreement § 5(a)(vi) (“If “Cross Default” is specified in the Schedule as applying to the party, the

occurrence or existence of (1) a default, event of default or other similar condition or event (however described) in

respect of such party, any Credit Support Provider of such party or any applicable Specified Entity of such party

under one or more agreements or instruments relating to Specified Indebtedness of any of them (individually or

collectively) in an aggregate amount of not less than the applicable Threshold Amount (as specified in the Schedule)

which has resulted in such Specified Indebtedness becoming, or becoming capable at such time of being declared,

due and payable under such agreements or instruments, before it would otherwise have been due and payable or (2)

a default by such party, such Credit Support Provider or such Specified Entity (individually or collectively) in

making one or more payments on the due date thereof in an aggregate amount of not less than the applicable

Threshold Amount under such agreements or instruments (after giving effect to any applicable notice requirement or

grace period).”). It should be noted that although the 2002 NAESB does not incorporate an Event of Default similar

to Cross Default under the ISDA, the 2006 NAESB does include such Event of Default if elected by the parties

15

Support Provider merges with or transfers substantially all of its assets to another entity, and

such transferee entity does not assume the transferor’s obligations under the ISDA Agreement

(“Merger Without Assumption”).77

In addition to Events of Default, the ISDA Master Agreement also contains Termination

Events, the occurrence of which may give rise to the termination and liquidation of Transactions

entered into under the Gas Annex that are affected by the Termination Event. Examples of

Termination Events under the ISDA include (i) when the passage of laws or other regulations

prevent the parties’ performance under the Agreement (“Illegality”);78

(ii) when a change in tax

laws or actions by taxing authorities would require a party to either pay more (or deduct from

amounts received more) than originally anticipated under the Agreement as a result of such tax

law or action (“Tax Event”);79

(iii) when a party, its Credit Support Provider or another Specified

Entity merges with or transfers substantially all of its assets to another entity, and the resulting

entity or transferee is “materially weaker” than immediately prior to such merger or transfer

(“Credit Event Upon Merger”);80

and (iv) when any other event occurs designated by the parties

(termed an “Indebtedness Cross Default”) as a NAESB “Additional Event of Default”. See discussion supra at

Section I(B)(2). 77

ISDA Master Agreement § 5(a)(viii) (“The party or any Credit Support Provider of such party consolidates or

amalgamates with, or merges with or into, or transfers all or substantially all its assets to, another entity and, at the

time of such consolidation, amalgamation, merger or transfer: — (1) the resulting, surviving or transferee entity fails

to assume all the obligations of such party or such Credit Support Provider under this Agreement or any Credit

Support Document to which it or its predecessor was a party by operation of law or pursuant to an agreement

reasonably satisfactory to the other party to this Agreement; or (2) the benefits of any Credit Support Document fail

to extend (without the consent of the other party) to the performance by such resulting, surviving or transferee entity

of its obligations under this Agreement.”). 78

ISDA Master Agreement § 5(b)(i) (“Due to the adoption of, or any change in, any applicable law after the date on

which a Transaction is entered into, or due to the promulgation of, or any change in, the interpretation by any court,

tribunal or regulatory authority with competent jurisdiction of any applicable law after such date, it becomes

unlawful (other than as a result of a breach by the party of Section 4(b)) for such party (which will be the Affected

Party): (1) to perform any absolute or contingent obligation to make a payment or delivery or to receive a payment

or delivery in respect of such Transaction or to comply with any other material provision of this Agreement relating

to such Transaction; or (2) to perform, or for any Credit Support Provider of such party to perform, any contingent

or other obligation which the party (or such Credit Support Provider) has under any Credit Support Document

relating to such Transaction.”). 79

ISDA Master Agreement § 5(b)(ii) (“Due to (x) any action taken by a taxing authority, or brought in a court of

competent jurisdiction, on or after the date on which a Transaction is entered into (regardless of whether such action

is taken or brought with respect to a party to this Agreement) or (y) a Change in Tax Law, the party (which will be

the Affected Party) will, or there is a substantial likelihood that it will, on the next succeeding Scheduled Payment

Date (1) be required to pay to the other party an additional amount in respect of an Indemnifiable Tax under Section

2(d)(i)(4) (except in respect of interest under Section 2(e), 6(d)(ii) or 6(e)) or (2) receive a payment from which an

amount is required to be deducted or withheld for or on account of a Tax (except in respect of interest under Section

2(e), 6(d)(ii) or 6(e)) and no additional amount is required to be paid in respect of such Tax under Section 2(d)(i)(4)

(other than by reason of Section 2(d)(i)(4)(A) or (B)).”). 80

ISDA Master Agreement § 5(b)(iv) (“If “Credit Event Upon Merger” is specified in the Schedule as applying to

the party, such party (“X”), any Credit Support Provider of X or any applicable Specified Entity of X consolidates or

amalgamates with, or merges with or into, or transfers all or substantially all its assets to, another entity and such

action does not constitute an event described in Section 5(a)(viii) but the creditworthiness of the resulting, surviving

or transferee entity is materially weaker than that of X, such Credit Support Provider or such Specified Entity, as the

case may be, immediately prior to such action (and, in such event, X or its successor or transferee, as appropriate,

will be the Affected Party).”).

16

as an “Additional Termination Event” under the ISDA Schedule (“Additional Termination

Event”).81

When compared to the 2002 NAESB, the Gas Annex, through the ISDA Master

Agreement, contains more events which may trigger the termination of the Agreement and

liquidation of transactions. However, industry participants should weigh whether the additional

Events of Default and Termination Events in the ISDA provide substantive benefit to the Gas

transaction at issue. For parties entering into a fairly short-term Gas transaction, the NAESB

Events of Default may provide adequate protection from the primary risk involved in short-term

deals: whether a counterparty pays amounts owed when due. For long-term Gas transactions,

however, parties may desire to either supplement the NAESB’s Events of Default to provide

protection against risks associated with long-term trading relationships, or use an ISDA

Agreement with Gas Annex.82

F. Termination and Liquidation of Gas Transactions

The methods of valuating terminated transactions in order to calculate an early

termination payment vary between the NAESB and the ISDA.

Under the NAESB, the Non-Defaulting Party determines, in good faith and in a

commercially reasonable manner, (i) the amount owed (whether or not then due) by each party

with respect to all Gas delivered and received between the parties under Terminated Transactions

on and before the Early Termination date, and (ii) all other applicable charges related to such

deliveries and receipts for which payment has not yet been made by the party that owes such

payment under the Contract.83

If the parties also elect on the NAESB Cover Sheet that “Early

Termination Damages Apply,” then the Non-Defaulting Party additionally liquidates and

accelerates each Terminated Transaction at its Market Value by pricing similar Gas transactions

at the same Delivery Point as the Terminated Transaction, and considering sources including, but

not limited to, NYMEX quotations, quotes from industry dealers, or similar Gas sales or

purchases from bona fide third-party offers.84

The Non-Defaulting Party then compares the

Market Value of each Terminated Transaction to the Contract Value for such transaction. If the

Market Value exceeds the Contract Value, then the difference in such values is due to Buyer; if

81

ISDA Master Agreement § 5(b)(v) (“If any “Additional Termination Event” is specified in the Schedule or any

Confirmation as applying, the occurrence of such event (and, in such event, the Affected Party or Affected Parties

shall be as specified for such Additional Termination Event in the Schedule or such Confirmation).”). 82

One commentator states the following on this issue: “In the context of a short-term trading contract, [the

NAESB’s] approach- limited to payment failures and other credit difficulties- [is] sufficient to protect the interests

of the short-term trader whose primary concern is either being paid for the natural gas that was supposed to be

purchased or sold or being reimbursed under Section 3.2…pursuant to the Cover Standard or the Spot Price

Standard, as appropriate…However, once parties have entered into a Confirmation for a long-term transaction under

a NAESB Contract, that solution is no longer adequate…Both parties are bound to perform for the required duration

of such Confirmation, unless there is an actual payment default or bankruptcy.” Karen Goepfert, “For the Long

Haul: The Suitability of the Base Contract for the Sale and Purchase of Natural Gas for Long-Term Transactions,”

27 Energy Law Journal 583, 593-94 (2006). 83

NAESB § 10.3.1. 84

NAESB § 10.3.1 (Early Termination Damages Apply).

17

the Contract Value exceeds the Market Value, then the difference in such values is due to

Seller.85

In contrast, payments on early termination under the ISDA Master Agreement are

determined pursuant to either “Market Quotation” or “Loss” calculations, as well as the “First

Method” or “Second Method” of payment—each as may be elected by the parties in the ISDA

Schedule.86

Market Quotation calculates the amount due upon early termination by determining

the difference between (i) the value of Terminated Transactions based on quotations from four

(4) leading dealers in the relevant market selected in good faith (“Reference Market-makers”)

and any other Unpaid Amounts owed to the Non-Defaulting Party; and (ii) the value of any

Unpaid Amounts owed to the Defaulting Party.87

Loss calculates the value of the Non-

Defaulting Party’s total losses and costs (or gains, expressed as a negative number) resulting

from the early termination and liquidation of Terminated Transactions, including any loss of

bargain, costs of funding, and costs of terminating, liquidating or reestablishing any hedge.88

85

Id. 86

ISDA Master Agreement § 6(e). 87

ISDA Master Agreement § 14 (“ “Market Quotation” means, with respect to one or more Terminated Transactions

and a party making the determination, an amount determined on the basis of quotations from Reference Market-

makers. Each quotation will be for an amount, if any, that would be paid to such party (expressed as a negative

number) or by such party (expressed as a positive number) in consideration of an agreement between such party

(taking into account any existing Credit Support Document with respect to the obligations of such party) and the

quoting Reference Market-maker to enter into a transaction (the “Replacement Transaction”) that would have the

effect of preserving for such party the economic equivalent of any payment or delivery (whether the underlying

obligation was absolute or contingent and assuming the satisfaction of each applicable condition precedent) by the

parties under Section 2(a)(i) in respect of such Terminated Transaction or group of Terminated Transactions that

would, but for the occurrence of the relevant Early Termination Date, have been required after that date. For this

purpose, Unpaid Amounts in respect of the Terminated Transaction or group of Terminated Transactions are to be

excluded but, without limitation, any payment or delivery that would, but for the relevant Early Termination Date,

have been required (assuming satisfaction of each applicable condition precedent) after that Early Termination Date

is to be included. The Replacement Transaction would be subject to such documentation as such party and the

Reference Market-maker may, in good faith, agree. The party making the determination (or its agent) will request

each Reference Market-maker to provide its quotation to the extent reasonably practicable as of the same day and

time (without regard to different time zones) on or as soon as reasonably practicable after the relevant Early

Termination Date. The day and time as of which those quotations are to be obtained will be selected in good faith by

the party obliged to make a determination under Section 6(e), and, if each party is so obliged, after consultation with

the other. If more than three quotations are provided, the Market Quotation will be the arithmetic mean of the

quotations, without regard to the quotations having the highest and lowest values. If exactly three such quotations

are provided, the Market Quotation will be the quotation remaining after disregarding the highest and lowest

quotations. For this purpose, if more than one quotation has the same highest value or lowest value, then one of such

quotations shall be disregarded. If fewer than three quotations are provided, it will be deemed that the Market

Quotation in respect of such Terminated Transaction or group of Terminated Transactions cannot be determined.”);

(“ “Reference Market-makers” means four leading dealers in the relevant market selected by the party determining a

Market Quotation in good faith (a) from among dealers of the highest credit standing which satisfy all the criteria

that such party applies generally at the time in deciding whether to offer or to make an extension of credit and (b) to

the extent practicable, from among such dealers having an office in the same city.”). 88

ISDA Master Agreement § 14 (“ “Loss” means, with respect to this Agreement or one or more Terminated

Transactions, as the case may be, and a party, the Termination Currency Equivalent of an amount that party

reasonably determines in good faith to be its total losses and costs (or gain, in which case expressed as a negative

number) in connection with this Agreement or that Terminated Transaction or group of Terminated Transactions, as

the case may be, including any loss of bargain, cost of funding or, at the election of such party but without

duplication, loss or cost incurred as a result of its terminating, liquidating, obtaining or reestablishing any hedge or

18

Once the amount owed upon early termination is calculated pursuant to Market

Quotation or Loss, a designation of either First or Second Method determines to whom such

amount is paid. Under the First Method, only the Non-Defaulting Party may be paid any

amounts owed to it upon an Early Termination Date.89

Thus, if amounts would otherwise be

owed to the Defaulting Party from the Non-Defaulting Party upon an Early Termination Date,

the Defaulting Party receives nothing—a clear risk that parties should consider in determining

whether to elect payment under the First Method. By contrast, the Second Method allows either

the Non-Defaulting Party or the Defaulting Party to receive amounts owed to it from the other

party upon an Early Termination Date.90

Where the parties fail to designate a payment measure

or method under the ISDA Master Agreement, Market Quotation and Second Method apply by

default.91

The various methods of liquidating transactions each contain inherent risks that a party

should consider in determining how to calculate termination amounts under trading agreements.

If parties rely on market quotations or other external sources in liquidating transactions to

calculate a termination amount (whether under the NAESB or the Market Quotation election

under the ISDA Master Agreement), it is possible that the market quotations or sources

incorporated into such calculation may not accurately reflect the value of such transactions—

potentially resulting in a loss or windfall to a party. Similarly, because the Loss method under

the ISDA Master Agreement allows the Non-Defaulting Party to determine its total losses and

costs with respect to Terminated Transactions without referencing any external market

quotations or sources, it is possible that such Loss calculation may include additional amounts

not otherwise contemplated under the NAESB or the Market Quotation calculation.

G. Setoff Rights

Parties to the NAESB or Gas Annex may elect for setoff rights to arise upon liquidation

and termination of Gas transactions. Setoff provisions generally allow a party to offset amounts

owed to it against amounts owed by it to the other party. The 2002 NAESB allows the parties to

elect on the Cover Sheet whether a Non-Defaulting Party may setoff a Net Settlement Amount

(i) against collateral held by the Non-Defaulting Party, or (ii) other amounts owed to the Non-

Defaulting Party by the Defaulting Party under any other agreements or arrangements.92

related trading position (or any gain resulting from any of them). Loss includes losses and costs (or gains) in respect

of any payment or delivery required to have been made (assuming satisfaction of each applicable condition

precedent) on or before the relevant Early Termination Date and not made, except, so as to avoid duplication, if

Section 6(e)(i)(1) or (3) or 6(e)(ii)(2)(A) applies. Loss does not include a party’s legal fees and out-of-pocket

expenses referred to under Section 11. A party will determine its Loss as of the relevant Early Termination Date, or,

if that is not reasonably practicable, as of the earliest date thereafter as is reasonably practicable. A party may (but

need not) determine its Loss by reference to quotations of relevant rates or prices from one or more leading dealers

in the relevant markets.”). 89

ISDA Master Agreement § 6(e). 90

Id. 91

Id. 92

2002 NAESB § 10.3.2; see discussion supra at Section I(B)(4).

19

Regardless of the election made by the parties, the Non-Defaulting Party will, at a minimum, be

permitted to setoff any Net Settlement Amount against amounts owed under the NAESB.93

The 1992 ISDA does not contain any setoff provisions. However, the 2002 ISDA

incorporates a setoff provision similar to the 2002 NAESB.94

Section 6(f) of the 2002 ISDA

provides that any Early Termination Amount payable to one party (the “Payee”) by the other

party (the “Payer”) will, at the option of the Non-Defaulting Party (with respect to an Event of

Default) or the Non-affected Party (with respect to a Termination Event), be setoff against any

other amounts owed by the Payee to the Payer, whether or not such payments arise under the

Agreement. While the 2002 ISDA contains equivalent rights of setoff as the 2002 NAESB,

parties trading under the 1992 ISDA may wish to avoid inconsistencies between the 1992 ISDA

and 2002 NAESB by incorporating a setoff provision into the ISDA Schedule which would

apply to Transactions under the Gas Annex. Setoff provisions are particularly important to

parties trading under multiple agreements or through affiliates, as such provisions protect against

credit and payment risks involved with the termination and liquidation of transactions.95

III. 2006 NAESB Compared to ISDA Gas Annex96

A. Events of Default

The 2006 NAESB, unlike the 2002 NAESB, includes the concept of Additional Event of

Default as a means by which the parties may terminate and liquidate affected Gas transactions.97

The Additional Events of Default under the 2006 NAESB are substantively identical to the

Default Under Specified Transaction and Cross Default Events of Default under the ISDA

Master Agreement.98

If a party prefers to use the NAESB but wants to incorporate additional

Events of Default found in the ISDA Master Agreement, it may be beneficial for the party to use

the 2006 NAESB instead of the 2002 NAESB. As discussed herein, the concepts of

Transactional Cross Default and Indebtedness Cross Default in the 2006 NAESB help mitigate a

party’s credit and commercial risks by looking to a counterparty’s performance under extrinsic

agreements in determining whether an Event of Default arises under the NAESB.99

93

Id. 94

See 2002 ISDA § 6(f). 95

See discussion supra at Section I(B)(4); see also discussion infra at Section IV(E), Section (V)(D), and Section

VI(D). 96

Many of the differences between the NAESB (both the 2002 and 2006 forms) and the Gas Annex have been

addressed in Section II herein. To the extent the 2002 NAESB differs from the 2006 NAESB but does not

substantively impact the analysis herein in Section II, such provisions are not discussed in Section III. However, to

the extent the analysis comparing the 2006 NAESB to the Gas Annex substantively differs from the analysis in

Section II herein, Section III addresses such differences. For a discussion of the differences between the 2002

NAESB and the 2006 NAESB, see discussion infra. at Section I. 97

See discussion supra at Section I(B)(2). 98

Compare 2006 NAESB § 2.31 and 2.33 (“Transactional Cross Default”) to ISDA Master Agreement § 5(a)(v)

(“Default Under Specified Transaction”); compare 2006 NAESB § 2.23 (“Indebtedness Cross Default”) to ISDA

Master Agreement § 5(a)(vi) (“Cross Default”). 99

See discussion supra at Section I(B)(2).

20

IV. EEI Compared to ISDA Power Annex100

A. Events of Default, Termination Events and Early Termination Date

The EEI contains Events of Default relating to (i) the failure by a Party or its Guarantor

to make payment when due if not remedied within three (3) Business Days after written

notice;101

(ii) false or misleading representations or warranties by a Party or its Guarantor;102

(iii)

the failure by a Party or its Guarantor to perform any material covenant or obligation in the

Agreement (other than a failure to deliver or receive the Product) if not remedied within three (3)

Business Days after written notice;103

(iv) bankruptcy of a Party or its Guarantor;104

(v) a Party’s

failure to satisfy credit obligations;105

(vi) a resulting entity’s or transferee’s failure to assume a

Party’s obligations under the EEI subsequent to a merger or transfer between such transferee and

a Party;106

(vii) defaults by a Party or any Specified Entity on agreements relating to

indebtedness for borrowed money;107

(viii) the failure of a guaranty issued by a Party’s

100

Capitalized terms used in this Section IV but not otherwise defined herein shall have the meanings set forth in the

EEI or the ISDA, as applicable. 101

EEI § 5.1(a) (“the failure to make, when due, any payment required pursuant to this Agreement if such failure is

not remedied within three (3) Business Days after written notice”) and (h)(ii) (“the failure of a Guarantor to make

any payment required…in any guaranty made in connection with this Agreement and such failure shall not be

remedied within three (3) Business Days after written notice”). 102

EEI § 5.1(b) (“any representation or warranty made by such Party herein is false or misleading in any material

respect when made or when deemed made or repeated”) and (h)(i) (“if any representation or warranty made by a

Guarantor in connection with this Agreement is false or misleading in any material respect when made or when

deemed made or repeated”). 103

EEI § 5.1(c) (“the failure to perform any material covenant or obligation set forth in this Agreement (except to

the extent constituting a separate Event of Default, and except for such Party’s obligations to deliver or receive the

Product, the exclusive remedy for which is provided in Article Four) if such failure is not remedied within three (3)

Business Days after written notice”) and (h)(ii) (the failure of a Guarantor to…perform any other material covenant

or obligation in any guaranty made in connection with this Agreement and such failure shall not be remedied within

three (3) Business Days after written notice”). 104

EEI § 5.1(d) (“such Party becomes bankrupt”) and (h)(iii) (“a Guarantor becomes Bankrupt”). 105

EEI § 5.1(e) (“the failure of such Party to satisfy the creditworthiness/collateral requirements agreed to pursuant

to Article Eight”). 106

EEI § 5.1(f) (“such Party consolidates or amalgamates with, or merges with or into, or transfers all or

substantially all of its assets to, another entity and, at the time of such consolidation, amalgamation, merger or

transfer, the resulting, surviving or transferee entity fails to assume all obligations of such Party under this

Agreement to which it or its predecessor was a party by operation of law or pursuant to an agreement reasonably

satisfactory to the other Party”). 107

EEI § 5.1(g) (“if the applicable cross default section in the Cover Sheet is indicated for such Party, the occurrence

and continuation of (i) a default, event of default or other similar condition or event in respect of such Party or any

other party specified in the Cover Sheet for such Party under one or more agreements or instruments, individually or

collectively, relating to indebtedness for borrowed money in an aggregate amount of not less than the applicable

Cross Default Amount (as specified in the Cover Sheet), which results in such indebtedness becoming, or becoming

capable at such time of being declared, immediately due and payable or (ii) a default by such Party or any other

party specified in the Cover Sheet for such Party in making on the due date therefor one or more payments,

individually or collectively, in an aggregate amount of not less than the applicable Cross Default Amount (as

specified in the Cover Sheet)”).

21

Guarantor to be in full force and effect;108

and (ix) the repudiation of a guaranty by a Party’s

Guarantor.109

The ISDA contains Events of Default substantially similar to the above-stated EEI Events

of Default.110

However, the ISDA also incorporates an Event of Default relating to defaults by a

party, its Credit Support Provider or any Specified Entity of the party with respect to any

Specified Transaction (such as rates, swaps, options, or other Transactions designated by the

parties) (“Default Under Specified Transaction”).111

Moreover, the ISDA contains Termination

Events such as Illegality, Tax Event and Credit Event Upon Merger not otherwise found in the

EEI, by which parties may terminate and liquidate Transactions.112

As discussed herein, a party should analyze the various commercial and credit risks

involved in each transaction to determine which Event(s) of Default may be necessary to

adequately protect such party.113

To avoid inconsistencies regarding termination and liquidation

of contracts, it may be beneficial for parties to incorporate similar Events of Default in each of its

trading agreements.

B. Notices

Section 10.7 of the EEI provides that all notices, requests, statements or payments shall

be made by hand delivery, United States mail, overnight courier or facsimile, unless otherwise

specified by the Parties on the Cover Sheet. Generally, notices under the EEI are subject to the

following conditions:

(i) If notice sent by facsimile or hand delivery is received during business

hours on a Business Day, such notice shall be deemed effective at the close of

business on the day actually received. If notice is received after business hours,

then such notice shall be effective at the close of business on the following

Business Day; and

(ii) If notice is sent by overnight United States mail or courier, notice shall be

effective on the next Business Day after it was sent.114

The effective date for the receipt of notices under the EEI is important because it directly impacts

the timing of Events of Default and the designation of an Early Termination Date. Any

108

EEI 5.1(h)(iv) (“the failure of a Guarantor’s guaranty to be in full force and effect for the purposes of this

Agreement (other than in accordance with its terms) prior to the satisfaction of all obligations of such Party under

each Transaction to which such guaranty shall relate without the written consent of the other Party”). 109

EEI 5.1(h)(v) (“a Guarantor shall repudiate, disaffirm, disclaim, or reject, in whole or in part, or challenge the

validity of any guaranty”). 110

See ISDA Master Agreement § 5(a)(i) – (iv) and (vi) – (viii). 111

ISDA Master Agreement § 5(a)(v); see discussion of ISDA Events of Default and Termination Events supra at

Section II(E). 112

ISDA Master Agreement § 5(b); see discussion supra at Section II(E). 113

See discussion supra at Section II(E). 114

EEI § 10.7.

22

modifications to timing requirements or other administrative procedures regarding notices may

increase the risk that a party will not be able to exercise early termination rights as quickly as

desired.115

Although the Power Annex does not contain provisions concerning the manner and

timing of notices, the ISDA Master Agreement contains notice provisions affecting all ISDA

Transactions—including Power Transactions.116

Importantly, the ISDA specifically excludes

facsimile, electronic messaging system and e-mail as a means of providing notices with respect

to the occurrence of Events of Default or the designation of an Early Termination Date.117

To avoid the risk that the manner, method or timing of a party’s notice may be

ineffective, such party may wish to incorporate similar notice provisions throughout its various

trading contracts.118

C. Automatic Early Termination

Automatic Early Termination is an option under the ISDA not found in the EEI.119

The

Automatic Early Termination election allows parties to disregard the procedures otherwise

required to designate an Early Termination Date, and instead provides that an Early Termination

Date shall immediately occur upon the occurrence of certain bankruptcy events.120

Automatic Early Termination is extremely valuable in jurisdictions without “safe harbor”

protections otherwise provided to parties under the United States Bankruptcy Code (the

“Bankruptcy Code”).121

However, in Transactions where both parties are located in the United

States, many parties do not elect Automatic Early Termination in recognition that Automatic

Early Termination may not be necessary to protect the Non-Defaulting Party, and (i) to control

the timing of when Transactions terminate under the ISDA; (ii) to continue the contractual

relationship and provide the Defaulting Party with time to cure; (iii) to negotiate better terms and

conditions with the counterparty in exchange for not terminating the Agreement immediately;

(iv) to avoid the risk that Transactions will terminate without the Non-Defaulting Party’s

knowledge, potentially exposing such party to un-hedged positions with other entities and

disrupting portfolio risk assumptions; and (v) in situations where the Non-Defaulting Party is

“out of the money”, to avoid immediately owing the Defaulting Party a Settlement Amount upon

such termination.122

115

See discussion supra at Section II(C). 116

Id. 117

1992 ISDA § 12(a) (preventing such notices by “facsimile or electronic messaging system”); 2002 ISDA § 12(a)

(preventing such notices by “electronic messaging system or e-mail”); see discussion supra at Section II(C). 118

See discussion supra at Section II(C). 119

See ISDA Master Agreement §6. 120

ISDA Master Agreement § 6(a). 121

Enochs and de la Pena, supra note 39, at 6-9. 122

See Craig R. Enochs, Fundi A. Mwamba, and Paul E. Vrana, “Early Termination and Liquidation Provisions as

Risk Tools in Master Energy Agreements”, State Bar of Texas Section Report – Oil, Gas and Energy Resources,

Vol. 29, No. 1, at 5 (September 2004).

23

Whether Automatic Early Termination creates or reduces risk by its absence or inclusion

in trading agreements depends on the jurisdiction in which the relevant parties are located and

the types of Transactions at issue in the contract. However, inclusion of Automatic Early

Termination in less than all of a party’s trading contracts with counterparties could leave the

Non-Defaulting Party exposed if such counterparties become insolvent or declare bankruptcy,

resulting in the immediate termination of only some—but not all—of the Transactions between

the parties.

D. Payments on Early Termination

After an Early Termination Date has been designated under the EEI or the ISDA, all

Transactions must be terminated and the value of such Transactions calculated in order to reach

an amount due under the agreement.123

The EEI requires the Non-Defaulting Party to calculate a

Settlement Amount for each Terminated Transaction in a “commercially reasonable manner.”124

By contrast, the ISDA requires the Non-Defaulting Party to determine amounts owed upon an

Early Termination Date using either Market Quotation or Loss calculations.125

As discussed

herein, inherent risks involved with various calculation methods should be analyzed by parties in

determining how to liquidate transactions under trading agreements.126

Another distinction between the EEI and ISDA relates to whether the Non-Defaulting

Party is required to make a Termination Payment to the Defaulting Party. The EEI provides that

after a Settlement Amount is calculated for each Terminated Transaction, the Non-Defaulting

Party shall net all Settlement Amounts into a single Termination Payment that is payable either

to or from the Non-Defaulting Party, as applicable.127

Thus, the EEI anticipates that the Non-

Defaulting Party may owe a Termination Payment to the Defaulting Party upon termination of all

Transactions under the Agreement.

The Power Annex, through the ISDA Master Agreement, allows the parties to designate

either First or Second Method to determine whether the Non-Defaulting Party may owe amounts

to the Defaulting Party upon an Early Termination Date. The Second Method allows either the

Non-Defaulting Party or the Defaulting Party to receive amounts owed to it from the other party

upon an Early Termination Date—similar to the structure of the EEI.128

However, unlike the

EEI, the ISDA’s First Method allows only the Non-Defaulting Party to be paid any amounts

owed to it upon an Early Termination Date.129

In determining whether to elect the First Method

under the ISDA Master Agreement, a party should consider the risk that if it defaults under the

Agreement, such party will not receive any termination payment—even if an amount would

otherwise be owed to it by the Non-Defaulting Party.130

123

EEI § 5.2; ISDA Master Agreement § 6(a) – (b). 124

EEI § 5.2. 125

ISDA Master Agreement § 6(e); see also discussion supra at Section II(F). 126

See discussion supra at Section II(F). 127

EEI § 5.3. 128

ISDA Master Agreement § 6(e); see discussion supra at Section II(F). 129

Id. 130

See discussion supra at Section II(F).

24

E. Setoff

A significant difference between the EEI and the Power Annex (through the ISDA

Master Agreement) relates to a party’s ability to setoff obligations under other agreements. The

1992 ISDA lacks a provision relating to setoff, while the 2002 ISDA includes such right.131

The

EEI, similar to the 2002 ISDA, allows the Non-Defaulting Party to setoff obligations under “any

other agreements, instruments or undertakings between the Defaulting Party and the Non-

Defaulting Party” upon the calculation of a Termination Payment.132

In addition, the Parties may

elect for the Non-Defaulting Party to have the right to setoff obligations owed by the Defaulting

Party’s Affiliate under other agreements outside of the EEI.133

As previously discussed herein, a

party’s ability to setoff amounts across transactions and affiliates helps mitigate potential credit

and payment risks involved in terminating and liquidating transactions.134

V. 1992 ISDA Compared to 2002 ISDA135

A. Payments on Early Termination

An important difference between the 1992 ISDA and the 2002 ISDA is the calculation

and payment of amounts owed by the parties upon the early termination and liquidation of

Transactions under the Agreement. The 1992 ISDA offers parties the choice between one-way

payment (the “First Method”) and two-way payment (the “Second Method”) of amounts owed

upon an Early Termination Date.136

The 2002 ISDA provides for only two-way payment,

requiring that the Non-Defaulting Party must pay amounts owed, if any, to the Defaulting Party

upon the occurrence of an Early Termination Date.137

Likewise, the 1992 ISDA’s election of valuing Terminated Transactions under either the

Loss or Market Quotation method is replaced in the 2002 ISDA with a hybrid valuation method

termed “Close-out Amount.”138

Close-out Amount is a calculation of the gains, losses, and costs

131

For a discussion of setoff rights under the 2002 ISDA, see discussion supra at Section II(G); see also discussion

supra at Sections I(B)(4) and infra at Sections V(C) and VI(D). 132

EEI § 5.6, Option A; 2002 ISDA Master Agreement § 6(f). 133

EEI § 5.6, Options B and C. 134

See discussion supra at Section I(B)(4). 135

For purposes of this Section V, any capitalized terms used herein but not otherwise defined herein shall have the

meanings set forth in the 1992 ISDA or the 2002 ISDA, as applicable. 136

1992 ISDA Master Agreement § 6(e); see discussion supra at Section II(F). 137

2002 ISDA § 6(e)(i). 138

See 2002 ISDA § 6(d)(i); see also 2002 ISDA § 14 (defining “Close-out Amount” in part as, “with respect to

each Terminated Transaction or each group of Terminated Transactions and a Determining Party, the amount of the

losses or costs of the Determining Party that are or would be incurred under then prevailing circumstances

(expressed as a positive number) or gains of the Determining Party that are or would be realized under then

prevailing circumstances (expressed as a negative number) in replacing, or in providing for the Determining Party

the economic equivalent of, (a) the material terms of that Terminated Transaction or group of Terminated

Transactions, including the payments and deliveries by the parties under Section 2(a)(i) in respect of that Terminated

Transaction or group of Terminated Transactions that would, but for the occurrence of the relevant Early

25

incurred in replacing or realizing the economic equivalent of the Terminated Transactions.139

The Close-out Amount includes (i) the cost of terminating, liquidating or re-establishing such

Transactions (so long as any such value does not duplicate other amounts already included in the

Close-out Amount calculation); and (ii) the value of the option rights of the parties.140

The party calculating the Close-out Amount (the “Determining Party”) enjoys flexibility

in its choice of price sources, including the option to use internal valuations so long as the

internal information used is of the same type used in valuing similar transactions in the ordinary

course of the Determining Party’s business.141

However, regardless of the valuation method

used, the Determining Party must use third-party quotations or market data in its valuations

unless it believes the information is not available or would not provide commercially reasonable

results.142

The quotations used in calculating the Close-out Amount may take into consideration

the creditworthiness of the Determining Party and any other credit support documentation

existing between the Determining Party and the third-party providing the quotation.143

The 2002

ISDA requires the Determining Party to “act in good faith and use commercially reasonable

procedures in order to produce a commercially reasonable result” when calculating the Close-out

Amount.144

Notably, the Close-out Amount calculation method under the 2002 ISDA somewhat

limits the risk associated with the Loss calculation under the 1992 ISDA, as Close-out Amount

generally requires the Determining Party to seek third-party quotations or market data in

calculating a termination amount instead of relying solely on internal information (as permitted

under the Loss method).145

Moreover, the risk associated with Market Quotation calculations

under the 1992 ISDA (i.e., that third-party quotations or market data may misconstrue the proper

value of a Terminated Transaction)146

is mitigated under the Close-out Amount method, as the

Determining Party is permitted to internally determine its losses and costs incurred in connection

with terminating and liquidating the Terminated Transactions.147

B. Events of Default

Termination Date, have been required after that date (assuming satisfaction of the conditions precedent in Section

2(a)(iii)) and (b) the option rights of the parties in respect of that Terminated Transaction or group of Terminated

Transactions.”). 139

Id. 140

2002 ISDA § 14 (“Close-out Amount”). 141

Id. 142

Id. 143

Id. 144

Id. 145

2002 ISDA § 14 (“Close-out Amount”, stating in part “The Determining Party will consider, taking into account

the standards and procedures described in this definition, quotations…or relevant market data…unless the

Determining Party reasonably believes in good faith that such quotations or market data are not readily available or

would produce a result that would not satisfy those standards.”); see also discussion supra at Section II(F). 146

See discussion supra at Section II(F). 147

2002 ISDA § 14 (“Close-out Amount”, allowing the Determining Party to consider “information…from internal

sources (including any of the Determining Party’s Affiliates) if that information is of the same type used by the

Determining Party in the regular course of business for the valuation of similar transactions.”); see also discussion

supra at Section II(F).

26

1. Cure Periods

The 2002 ISDA modifies the cure periods contained in certain 1992 ISDA Events of

Default. Specifically, the 2002 ISDA (i) reduces the cure period for a failure to pay or deliver

pursuant to Section 5(a)(i) from three (3) Local Business Days to one (1) Local Business Day

following notice of such failure; (ii) reduces the cure period for a payment Default Under a

Specified Transaction pursuant to Section 5(a)(v)(2) from three (3) Local Business Days to one

(1) Local Business Day; and (iii) reduces the cure period for an involuntary bankruptcy filing

pursuant to Section 5(a)(vii)(1)(B) from thirty (30) days to fifteen (15) days.148

Compared to the

shortened cure periods under the 2002 ISDA, the longer cure periods under the 1992 ISDA

create potential risk for the Non-Defaulting Party upon the occurrence of an Event of Default, as

the Non-Defaulting Party must wait a longer time period before exercising its termination rights

when a Defaulting Party’s conduct indicates financial distress.

2. Breach of Agreement

The 2002 ISDA incorporates additional language to the Breach of Agreement Event of

Default in Section 5(a)(ii), creating an Event of Default when “[a] party disaffirms, disclaims,

repudiates or rejects, in whole or in part, or challenges the validity of, this Master Agreement,

any Confirmation executed and delivered by that party or any Transaction evidenced by such a

Confirmation (or such action is taken by any person or entity appointed or empowered to operate

it or act on its behalf).”149

Notably, the thirty (30) day cure period relating to breaches of the

Agreement under 5(a)(ii)(1) does not apply to the new Event of Default contained in Section

5(a)(ii)(2). A party transacting under the 1992 ISDA may wish to include the above-stated Event

of Default from the 2002 ISDA in order to mitigate the risk that a counterparty will reject or

challenge the validity of the Agreement.

3. Default Under Specified Transaction

The 2002 ISDA expands on the concept of Default Under Specified Transaction found in

the 1992 ISDA in five specific areas:

(i) With respect to defaults in making any delivery under a Specified

Transaction or credit support arrangements, such default does not rise to an Event

of Default under the ISDA unless the default results in the liquidation or

termination of all outstanding transactions under the documentation relating to

the Specified Transaction.150

By requiring liquidation and termination of all

outstanding transactions under any documentation relating to the Specified

Transaction before an Event of Default arises, the 2002 ISDA potentially exposes

the Non-Defaulting Party to risk by increasing the procedures required before the

148

Compare 2002 ISDA § 5(a)(1) to 1992 ISDA § 5(a)(1); compare 2002 ISDA § 5(a)(v)(2) to 1992 ISDA §

5(a)(v); compare 2002 ISDA § 5(a)(vii)(4)(B) to 1992 ISDA § 5(a)(vii)(4)(B). 149

2002 ISDA § 5(a)(ii)(2). 150

2002 ISDA § 5(a)(v)(3).

27

Non-Defaulting Party may exercise its termination rights against the Defaulting

Party;

(ii) Under the 2002 ISDA, a “Default Under Specified Transaction” may be

triggered by a party’s default under a credit support arrangement relating to a

Specified Transaction.151

Defaults under credit support arrangements relating to

Specified Transactions are not addressed in the 1992 ISDA. Without such

language, parties may not be adequately protected from the risk that a

counterparty could default on credit support arrangements relating to Specified

Transactions, yet no Event of Default occur;

(iii) As discussed herein, the 2002 ISDA reduces the cure period for the failure

to make a final payment or Early Termination Payment in respect of a Specified

Transaction from three (3) Local Business Days to one (1) Local Business

Day.152

The reduced cure period decreases the Non-Defaulting Party’s credit

risks by allowing such party to promptly exercise its termination rights;

(iv) The concept of repudiation of a Specified Transaction contained in the

1992 ISDA was modified in the 2002 ISDA in two significant ways: (i) the

phrase “or challenges the validity of” was added after the phrase “disaffirms,

disclaims, repudiates or rejects” to reduce ambiguity as to whether a party’s

challenge to the Agreement constitutes a repudiation; and (ii) the Non-Defaulting

Party is required to possess evidence of such repudiation that is executed and

delivered by the Defaulting Party, its Credit Support Provider, or a Specified

Entity.153

Under the 2002 language, a party avoids the risk that a counterparty’s

challenge of the Agreement may not constitute a repudiation (and thus an Event

of Default). However, the 2002 ISDA also provides some protection to the party

challenging the validity of the Agreement, as the Non-Defaulting Party must

possess evidence of any claimed repudiation before declaring an Event of Default

under the ISDA; and

(v) The definition of “Specified Transaction” has been broadened to include

additional types of transactions market participants commonly add to the ISDA

Schedule, such as repos, and includes a “catch-all” clause designed to include

any future derivative products not specifically enumerated in such definition.154

151

Id. 152

2002 ISDA § 5(a)(v)(2); see discussion supra at Section V(B)(1). 153

2002 ISDA § 5(a)(v)(4). 154

2002 ISDA § 14 (“ “Specified Transaction” means, subject to the Schedule, (a) any transaction (including an

agreement with respect to any such transaction) now existing or hereafter entered into between one party to this

Agreement (or any Credit Support Provider of such party or any applicable Specified Entity of such party) and the

other party to this Agreement (or any Credit Support Provider of such other party or any applicable Specified Entity

of such other party) which is not a Transaction under this Agreement but (i) which is a rate swap transaction, swap

option, basis swap, forward rate transaction, commodity swap, commodity option, equity or equity index swap,

equity or equity index option, bond option, interest rate option, foreign exchange transaction, cap transaction, floor

transaction, collar transaction, currency swap transaction, cross-currency rate swap transaction, currency option,

credit protection transaction, credit swap, credit default swap, credit default option, total return swap, credit spread

28

Such expanded definition avoids the risk that certain types of Transactions may

not otherwise be considered “Specified Transactions” under the 2002 ISDA.

4. Cross Default

The formula for determining a Cross Default under the 2002 ISDA permits the

aggregation of amounts owed by a party under multiple defaults. In determining whether a party

has exceeded its Cross Default threshold amount (thus triggering a Cross Default), the

calculating party shall determine (i) the principal amount of the Defaulting Party’s accelerated

obligations relating to agreements or instruments for Specified Indebtedness; plus (ii) any

Unpaid Amount(s) by the Defaulting Party under such agreements or instruments for Specified

Indebtedness.155

In the 1992 ISDA, a Defaulting Party’s accelerated obligations could not be

combined with its Unpaid Amounts with respect to Specified Indebtedness in order to evidence a

Cross Default.156

The modification under the 2002 ISDA provides the Non-Defaulting Party

with additional protection against the Defaulting Party’s credit risk. By analyzing both the

Defaulting Party’s Unpaid Amount(s) and accelerated obligations under Specified Transactions

in determining whether a Cross Default has occurred, a Non-Defaulting Party may be able to

declare an Event of Default under the 2002 ISDA sooner than under the terms of the 1992 ISDA.

5. Merger Without Assumption

The types of events that constitute a “merger” under the “Merger Without Assumption”

Event of Default have been broadened to include reorganization, reincorporation and

reconstitution under the 2002 ISDA.157

Such language protects the Non-Defaulting Party from

credit risk by expanding the circumstances under which the Non-Defaulting Party may be able to

declare an Event of Default.

6. Credit Support Default

Unlike the 1992 ISDA, the 2002 ISDA provides that if a security interest granted

pursuant to a Credit Support Document fails to be in full force and effect for purposes of the

ISDA , such event shall constitute a Credit Support Default.158

By expanding the definition of

transaction, repurchase transaction, reverse repurchase transaction, buy/sell-back transaction, securities lending

transaction, weather index transaction or forward purchase or sale of a security, commodity or other financial

instrument or interest (including any option with respect to any of these transactions) or (ii) which is a type of

transaction that is similar to any transaction referred to in clause (i) above that is currently, or in the future becomes,

recurrently entered into in the financial markets (including terms and conditions incorporated by reference in such

agreement) and which is a forward, swap, future, option or other derivative on one or more rates, currencies,

commodities, equity securities or other equity instruments, debt securities or other debt instruments, economic

indices or measures of economic risk or value, or other benchmarks against which payments or deliveries are to be

made, (b) any combination of these transactions and (c) any other transaction identified as a Specified Transaction in

this Agreement or the relevant confirmation.”). 155

2002 ISDA § 5(a)(vi). 156

See 1992 ISDA § 5(a)(vi). 157

2002 ISDA § 5(a)(viii). 158

2002 ISDA § 5(a)(iii)(1).

29

Credit Support Default, the 2002 ISDA protects the Non-Defaulting Party from the risk that its

security interest in a Credit Support Document could fail without giving rise to an Event of

Default under the ISDA.

C. Setoff

The 1992 ISDA does not contain any setoff provision. The 2002 ISDA, however,

expressly permits the Non-Defaulting Party to setoff any amounts owing between the parties

against any Early Termination Amount.159

Notably, cross-product setoff is permitted under the

standard 2002 ISDA language, but cross-Affiliate setoff is not incorporated into such provision.

As discussed herein, setoff provisions benefit parties by mitigating credit and commercial risks

involved in the termination and liquidation of transactions.160

VI. CTA Compared to ISDA Coal Annex161

A. Confirmation Procedures

The CTA allows Buyers and Sellers of physical coal to enter into separate purchase

Transactions in writing, by telephone conversation, or electronic trading exchange.162

The

Parties are legally bound by the terms of a Transaction at the moment such terms (whether oral

or written) are agreed-upon by the Parties.163

Buyer shall promptly provide Seller with a written

Confirmation setting forth the commercial terms the relevant Transaction, including but not

limited to Transaction Quantity, Term, Nomination Period(s), Scheduling, Transaction Price,

Source(s), Delivery Point(s), Specifications, Rejection Limits, premiums and/or penalties, and

any terms for an Option Transaction (if applicable).164

If the Party receiving the Confirmation

(“Receiving Party”) disputes the Transaction’s commercial terms, it must provide notice to the

Sending Party within three (3) Business Days.165

Otherwise, the Confirmation is deemed correct,

binding and conclusive evidence of the relevant Transaction.166

If the Receiving Party properly

provides notice of a dispute, the Parties then must use “Commercially Reasonable Efforts” to

resolve the dispute within ten (10) Business Days. If such dispute cannot be resolved, either

Party may seek any other remedy available to it under the CTA.167

Though the Coal Annex (through the ISDA Master Agreement) contemplates that parties

shall enter into Transactions evidenced by written Confirmations, the specific details concerning

159

2002 ISDA § 6(f); see discussion supra at Section II(G). 160

See discussion supra at Section II(G); see also discussion supra at Section IV(E) and infra at Section VI(D). 161

For purposes of this Section VI, any capitalized terms used herein but not otherwise defined herein shall have the

meanings set forth in the CTA or the Coal Annex, as applicable. 162

CTA § 1.1. 163

Id. 164

CTA §1.2(a). 165

CTA § 1.2(b). 166

Id. 167

Id.

30

the formation of Transactions and exchange of Confirmations found in the CTA is not similarly

found in the ISDA.168

As previously discussed herein, parties should analyze the potential risks

involved in both oral and written transaction procedures in order to determine which process to

incorporate into trading agreements.169

B. Audit Rights

Section 6.3 of the CTA requires Parties to maintain records relating to Coal sales and

purchases for at least two (2) years after the completion or termination of the relevant

Transaction.170

Each Party has the express right to examine the records of the other Party in

order to verify the accuracy of statements, charges or calculations made under the CTA.171

Notably, a Party may only examine the other Party’s records on one (1) occasion per year with

respect to each Transaction.172

If an examination reveals that a statement or invoice was

incorrect, an adjusted payment shall promptly be made by the relevant Party.173

If a Party does

not object to any incorrect statement or invoice within two (2) years from the date such

statement, charge or computation was rendered, a Party’s right to an adjustment shall lapse.174

The Coal Annex does not contain any similar provision regarding a party’s right to audit

records and adjust invoices. Without any audit rights, parties operating under the Coal Annex

may be subject to the risk that incorrect invoices or statements are not subsequently corrected

and settled among the parties. Accordingly, parties transacting under the Coal Annex may

consider incorporating language similar to the CTA’s audit provision either in the ISDA

Schedule or as an additional provision to the Coal Annex.

C. Events of Default

The CTA and Coal Annex (through the ISDA Master Agreement) each contain similar

Events of Default relating to: (i) failure by a Party to pay amounts owed when due (“Failure to

Pay”);175

(ii) failure by a Party to perform other obligations (other than making payments or

deliveries) under the Agreement (“Failure of Other Obligations”);176

(iii) failure by a Party or its

Guarantor under any applicable credit obligations (“Credit Support Default”);177

(iv)

misrepresentations by a Party (“Misrepresentations”);178

(v) Cross Default by a Party under

168

ISDA Master Agreement § 9.2(e)(ii); see recitals to ISDA Master Agreement, defining “Confirmation” as

“documents and other confirming evidence exchanged between the parties confirming [ISDA] Transactions.” See

discussion supra at Section II(A). 169

See discussion supra at Section II(A). 170

CTA § 6.3. 171

Id. 172

Id. 173

Id. 174

CTA § 6.3. 175

CTA § 8.1(a); ISDA Master Agreement § 5(a)(i). 176

CTA § 8.1(b); ISDA Master Agreement § 5(a)(ii). 177

CTA §§ 8.1(d) and (h); ISDA Master Agreement § 5(a)(iii). 178

CTA § 8.1(f); ISDA Master Agreement § 5(a)(iv).

31

agreements relating to indebtedness for borrowed money (“Cross Default”);179

(vi) bankruptcy or

insolvency proceedings against a Party (“Bankruptcy”);180

and (vii) failure by Seller to provide

reasonable assurances as to future shipments of Coal, after non-conforming shipments are

delivered to Buyer.181

Though the above-stated Events of Default are similar in concept in both the CTA and

ISDA, some specific differences exist that parties should consider in analyzing Coal

Transactions under the CTA and ISDA:

1. Failure to Pay

Under the CTA, the cure period for a Party to remedy any failure to pay amounts owed

when due is three (3) Business Days after written notice.182

Such cure period is consistent with

the 1992 ISDA, but the 2002 ISDA provides a cure period of one (1) Business Day.183

The CTA

and the 1992 ISDA impose greater credit risk to a Non-Defaulting Party than if such party were

transacting under the 2002 ISDA, as the CTA and 1992 ISDA require the Non-Defaulting Party

to wait three (3) Business Days before exercising termination rights against a Defaulting Party

instead of one (1) Business Day under the 2002 ISDA.

2. Failure of Other Obligations

An Event of Default arises under the CTA when a Party fails to comply with its material

obligations under a Transaction or the CTA (except failures to pay or deliver) if such default

continues uncured for ten (10) Business Days after written notice.184

If it is impracticable or

impossible to cure such failure within ten (10) Business Days, the cure period is extended for an

additional period reasonably necessary to remedy the failure, provided that (i) the defaulting

Party must diligently be pursuing a remedy within such additional cure period; and (ii) the

additional cure period may not exceed sixty (60) days.185

Similarly, the ISDA contains an Event of Default upon a party’s failure to comply with or

perform any agreement or obligation under the ISDA (except failures to pay or deliver).186

179

CTA § 8.1(g); ISDA Master Agreement § 5(a)(vi). 180

CTA § 8.1(c); ISDA Master Agreement § 5(a)(vii). 181

CTA § 8.1(e); Coal Annex, Appendix 1, § 13. Generally, the CTA and Coal Annex provide that if Seller delivers

three (3) non-conforming shipments within any three-month period, or if two (2) out of four (4) consecutive

shipments under a single Transaction are non-conforming, Buyer may give notice to Seller and suspend the receipt

of all future shipments, except those already loaded or in transit. Upon receipt of notice, Seller is permitted ten (10)

days in which to provide assurances of performance acceptable to Buyer that future shipments shall be conforming

to specifications. If Seller either fails to deliver the assurances of performance, or delivers any non-conforming

shipments within the three-month period following the request for assurances of performance, Buyer may declare an

Event of Default with respect to the transaction. CTA § 5.3; Coal Annex, Appendix 1, § 13. 182

CTA § 8.1(a). 183

Compare CTA § 8.1(a) and 1992 ISDA § 5(a)(1) to 2002 ISDA § 5(a)(1). 184

CTA § 8.1(b). 185

Id. 186

See 1992 ISDA § 5(a)(ii); 2002 ISDA § 5(a)(ii).

32

However, the cure period for remedying such default is thirty (30) days under the 1992 ISDA

and fifteen (15) days under the 2002 ISDA.187

Moreover, neither ISDA form allows an

additional cure period of up to sixty (60) days if a Defaulting Party is not able to remedy such

failure because of impossibility or impracticability.

In comparing the CTA to the ISDA, parties should analyze the risk created by the

agreements’ relevant cure periods before an Event of Default can be declared. The longer a

Non-Defaulting Party must wait before declaring an Event of Default, the more likely such party

may be subject to adverse credit risk with respect to the Defaulting Party.188

3. Bankruptcy

The CTA includes an Event of Default when a Party is subject to a “Bankruptcy

Proceeding”.189

“Bankruptcy Proceeding” is specifically limited to situations where a Party:

(i) makes an assignment or any general arrangement for the benefit of

creditors;

(ii) files a petition or otherwise commences, authorizes or acquiesces in the

commencement of a proceeding or cause of action under any bankruptcy or

similar law for the protection of creditors;

(iii) has such a petition filed against it, and such petition is not dismissed or

withdrawn within thirty (30) days after such filing;

(iv) otherwise becomes bankrupt or insolvent (however evidenced); or

(v) is unable to pay its debts as they fall due.190

The ISDA contains a similar Event of Default, but the various actions which may constitute

“bankruptcy” under the ISDA are broader than those actions in the CTA’s definition of

“Bankruptcy Proceeding”. For example, a Bankruptcy Event of Default under the ISDA may

arise when a Party passes a resolution for its winding-up, official management or liquidation,191

or when a Party becomes subject to the appointment of an administrator, provisional liquidator,

conservator, receiver, trustee, custodian or similar official for it or for all or substantially all of

its assets.192

Because the CTA does not expressly incorporate such concepts in the definition of

“Bankruptcy Proceeding”, Parties transacting under the CTA may encounter risk if a

counterparty’s actions—though evidencing potential insolvency—do not otherwise give rise to

an Event of Default under the CTA.

187

Id. 188

See discussion supra at Section V(B)(1). 189

CTA § 8.1(c). 190

CTA § 11 (“Bankruptcy Proceeding”). 191

ISDA Master Agreement § 5(a)(vii)(5). 192

ISDA Master Agreement § 5(a)(vii)(6).

33

4. Material Adverse Change

The CTA contains an Event of Default not found in the ISDA relating to the occurrence

of a Material Adverse Change with respect to a Party.193

The structure of the CTA allows the

Parties to elect an applicable definition for “Material Adverse Change” on the Cover Sheet.194

The first definition of Material Adverse Change contained on the CTA Cover Sheet relates to a

credit rating trigger, specifying that a Material Adverse Change occurs if a Party or a Party’s

Guarantor has any long-term, senior, unsecured debt not supported by third-party enhancement

that is rated by S&P or Moody’s below a set credit rating negotiated by the Parties.195

The

second election on the CTA Cover Sheet provides that a Material Adverse Change means an

event that would have a material adverse effect on the operations, financial condition or business

of a Party taken as a whole, other than as a result of seasonal changes, general economic

conditions or other considerations affecting the applicable industry.196

Importantly, even if an event which would otherwise constitute a Material Adverse

Change occurs with respect to a Party, such event shall not be considered an Event of Default

under the CTA if the Defaulting Party establishes and maintains, for so long as the Material

Adverse Change continues, Performance Assurance with the Non-Defaulting Party in an amount

equal to the sum of (i) the Early Termination Payment that would be owed to the Non-Defaulting

Party, plus (ii) if the Non-Defaulting Party is Seller, the aggregate of amounts Seller is entitled to

receive under each Transaction for Coal scheduled during the sixty (60) day period preceding the

Material Adverse Change.197

The inclusion of such Event of Default under the CTA mitigates a Party’s credit risk

when a counterparty (or its Guarantor) indicates signs of financial distress—such as a ratings

downgrade or an event that negatively impacts the financial condition of the Party or Guarantor.

Even if an event which would otherwise constitute a Material Adverse Change occurs, the credit

risk of the non-affected Party is mitigated by the requirement that the affected Party post

Performance Assurance to secure its obligations. If Performance Assurance is properly

provided, an Event of Default does not arise because the non-affected Party is protected from

immediate credit risk. However, if the affected Party does not provide Performance Assurance

as required under the CTA, the non-affected Party may mitigate its credit risk by declaring an

Event of Default and terminating the agreement.

5. Other Events of Default and Termination Events Under the ISDA

The ISDA contains certain Events of Default and Termination Events not found in the

CTA. For example, the ISDA contains Events of Default relating to Defaults Under Specified

193

CTA § 8.1(i). 194

CTA Cover Sheet, § 8.1(i). 195

Id. 196

Id. 197

CTA § 8.1(i).

34

Transactions and Mergers Without Assumption.198

Also, the ISDA contains Termination Events

such as Illegality, Tax Event and Credit Event Upon Merger not addressed in the CTA.199

As

previously discussed herein, the inclusion of such additional Events of Default and Termination

Events may help mitigate the Non-Defaulting Party’s credit and payment risks with respect to

the Defaulting Party.200

If a party wishes to receive the protections afforded by such ISDA

Events of Default and Termination Events, it may consider using a Coal Annex instead of the

CTA, or incorporating such ISDA events as additional provisions to the CTA.

D. Setoff Rights

The CTA provides that if an Event of Default occurs, the Non-Defaulting Party has the

right to setoff any amounts which the Defaulting Party owes the Non-Defaulting Party under the

CTA against any amounts the Non-Defaulting Party owes the Defaulting Party under the

CTA.201

Such provision is similar to language contained in the 2002 ISDA; however, the 1992

ISDA does not contain any express setoff rights.202

As previously discussed herein, setoff

provisions mitigate a party’s credit and commercial risks across transactions and affiliates and

should be considered by parties in drafting trading agreements.203

E. Waiver of Jury Trial

Any proceedings arising out of or relating to the CTA (or any Coal Transaction under the

CTA) must be resolved by a judge trial without a jury, and CTA Parties expressly waive any

right to a trial by jury to the extent permitted under applicable law.204

Neither the Coal Annex

nor the ISDA contains a similar waiver of jury trial provision, creating risk that parties under the

ISDA may be subject to resolving disputes through the use of a jury instead of a trial judge or

other alternative dispute resolution method.

F. Transfer and Assignment

Under both the CTA and the Coal Annex (through the ISDA Master Agreement), parties

generally may not transfer or assign any rights or obligations under the agreement without the

prior written consent of the other party.205

However, the CTA provides three (3) exceptions

when a Party may effect a transfer without the consent of the other Party:

198

ISDA § 5(a)(v) and 5(a)(viii). See discussion of ISDA Events of Default supra at Section II(E). 199

ISDA § 5(b)(i) (Illegality); 1992 ISDA § 5(b)(ii) and 2002 ISDA § 5(b)(iii) (Tax Event); 1992 ISDA § 5(b)(iv)

and 2002 ISDA § 5(b)(v) (Credit Event Upon Merger). See discussion of ISDA Termination Events supra at

Section II(E). 200

See discussion supra at Section II(E). 201

CTA § 8.3. 202

2002 ISDA § 6(f); see discussion supra at Section II(G). 203

See discussion supra at Sections I(B)(4), II(G), IV(E) and V(C). 204

CTA § 9. 205

Compare CTA § 10.1 to ISDA Master Agreement § 7.

35

(i) a transfer, sale, pledge, encumbrance or assignment of the CTA, any

Transactions under the CTA or any accounts, revenues or proceeds relating to the

CTA in connection with any financing or other financial arrangements;

(ii) a transfer or assignment of the CTA and/or any Transaction to an Affiliate

of such Party as long as the Affiliate is at least as creditworthy as the assignor;

and

(iii) a transfer or assignment of the CTA and/or any Transaction to any Person

succeeding to all or substantially all of the assets of such Party by way of merger,

reorganization or otherwise.206

Upon any such transfer, the transferor is not relieved from its obligations to fully perform under

the CTA or any Transaction.207

Though the ISDA contains exceptions as to when a party may implement a transfer or

assignment without counterparty consent, such exceptions differ from the CTA.208

Unlike the

CTA, the ISDA allows a party to transfer all or any part of its interest in amounts payable to it by

the Defaulting Party with respect to termination payments.209

However, the ISDA does not

permit transfers to a party’s Affiliates or in connection with financial arrangements without the

express written consent of the other party.210

Any assignment or transfer relating to the CTA or ISDA potentially creates risk. If the

CTA or ISDA requires the assignor to gain consent of the other party before making an

assignment, the assignor encounters risk that the other party may not allow such assignment to

proceed. Both the ISDA and CTA mitigate this risk by providing exceptions where prior written

consent is not required to effect certain types of transfers.211

However, assignments or transfers

pursuant to such exceptions create risk for the non-assigning party. For example, if a party under

the CTA assigns the agreement to a third-party pursuant to a financial arrangement (such that

consent of the other party is not required), such third-party’s creditworthiness and structure may

increase the non-assigning party’s credit and commercial risks under the agreement.212

G. Notices

Section 10.3 of the CTA provides that all notices, requests, statements or payments shall

be made by letter, facsimile, electronically or other documentary form unless otherwise specified

206

CTA § 10.1. 207

Id. 208

Compare CTA § 10.1 to ISDA § 7(a)-(b). 209

ISDA § 7(b). 210

ISDA § 7(a)-(b). 211

See ISDA § 7(a)-(b); CTA § 10.1. 212

E.g., if a third-party assignee is facing litigation or regulatory issues potentially affecting performance under the

CTA at the time of the assignment.

36

by the Parties on the Cover Sheet. Generally, notices under the CTA are subject to the following

terms and conditions:

(i) Notice sent by electronic means, facsimile or hand delivery shall be

deemed to have been received by the close of the Business Day on which it was

transmitted or delivered (unless transmitted or delivered after close of business,

in which case such notice shall be deemed to be received at the close of the

following Business Day); and

(ii) Notice by overnight mail or courier shall be deemed to have been received

one (1) Business Day after it was sent.213

The effective dates for the receipt of notices under the CTA directly impact the timing of Events

of Default and the designation of Early Termination Dates. Any modifications to timing

requirements or other administrative procedures regarding notices may increase the risk that a

party cannot exercise early termination rights as quickly as desired.214

Although the Coal Annex does not contain provisions concerning the manner and timing

of notices, the ISDA Master Agreement contains notice provisions affecting all ISDA

Transactions—including Coal Transactions.215

Importantly, the ISDA specifically prevents

parties from providing notices by facsimile, electronic messaging system or e-mail with respect

to Events of Default or designating an Early Termination Date.216

To avoid the risk that the manner, method or timing of a party’s notice may be

ineffective, a party may wish to incorporate similar notice provisions throughout its various

trading contracts.217

H. Confidentiality

The CTA contains a confidentiality clause not otherwise found in the Coal Annex or the

ISDA Master Agreement. Pursuant to Section 10.4 of the CTA, no Party may disclose the terms

of any Transaction to a third-party without the other Party’s prior written consent, unless (i) such

third-party is a Party’s and/or its Affiliates’ employees, lenders, counsel, accountants, lessors,

landowners and prospective permitted purchasers, directly or indirectly, of a Party or all or

substantially all of a Party’s assets or any of its rights under the CTA or any Transactions, in

each case only if such third-party has agreed to keep such terms confidential; (ii) disclosure is

necessary to comply with any applicable law, order, regulation or exchange rule.218

If disclosure

is required by law, regulation or order, each Party must notify the other Party of any proceeding

213

CTA § 10.3. 214

See discussion supra at Section II(C). 215

ISDA Master Agreement § 12; for a discussion of ISDA notice provisions, see discussion supra at Section II(C). 216

1992 ISDA § 12(a) (preventing such notices by “facsimile or electronic messaging system”); 2002 ISDA § 12(a)

(preventing such notices by “electronic messaging system or e-mail”); see discussion supra at Section II(C). 217

See discussion supra at Section II(C). 218

CTA § 10.4.

37

of which it is aware which may result in confidential information being disclosed, and must

make Commercially Reasonable Efforts to prevent or limit such disclosure.219

Because no similar provision is contained in the ISDA, parties using the Coal Annex may

be exposed to the risk that confidential information regarding the Agreement or any Coal

Transaction may be provided to third-parties without the affected party’s knowledge or consent.

To avoid such risk, parties should consider incorporating a confidentiality provision either in the

ISDA Schedule or the Coal Annex to adequately protect against the improper disclosure of

proprietary information.

I. Severability and Survival of Rights

If any portion of the CTA is determined to be unlawful by any applicable court or law or

regulatory agency, or is deemed unlawful because of a statutory change, such determination shall

not affect the lawful obligations arising under the CTA or any Transaction.220

In such case, the

Parties are required to promptly renegotiate the unlawful terms in order to restore the CTA or

any relevant Transaction as near as possible to its original intent and effect.221

Moreover, the

CTA generally provides that all indemnity and audit rights under the agreement shall survive for

two (2) years.222

Neither the Coal Annex nor the ISDA Master Agreement contains a severability clause

requiring the parties to negotiate and reinstate provisions determined to be unlawful. To the

contrary, the ISDA provides that if a change in law or regulations results in a party being unable

to perform any material obligations under the Agreement or any Credit Support Document, such

action may lead to termination and liquidation of Affected Transactions and the ISDA.223

The absence of a severability clause creates risk among the parties relating to proper

termination of the Agreement. If any portion of the ISDA is found unlawful (even if such

unlawful provision is immaterial to the performance of the Agreement), a counterparty may

attempt to terminate the entire Agreement because of such unlawful provision. By including a

severability provision in the ISDA Schedule or Coal Annex, parties can avoid such risk and still

operate under the Coal Annex while negotiating the modification of any unlawful terms.

J. Forward Contract

The CTA includes a statement indicating that the Parties “agree that Transactions for the

sale and purchase of Coal shall constitute ‘forward contracts’, and that the Parties shall constitute

‘forward contract merchants’ within the meaning of the United States Bankruptcy Code.”224

Such language is not included in the Coal Annex or the ISDA Master Agreement, but often is

included by parties as an additional representation in the ISDA Schedule.

219

Id. 220

CTA § 10.7. 221

Id. 222

Id. 223

ISDA § 5(b)(i). 224

CTA § 10.9.

38

The significance of a Transaction constituting a “forward contract” and the parties

constituting “forward contract merchants” directly relates to rights granted under the Bankruptcy

Code. Generally, once a party files for bankruptcy, the automatic stay limits the rights of

creditors in seeking payments due under the debtor’s contracts. However, forward contracts are

expressly exempt from the automatic stay, and a forward contract merchant may exercise any

contractual right under a forward contract (i) to terminate, liquidate and accelerate the forward

contract; and (ii) to offset or net out any termination values under the forward contract. 225

Although the determination of whether an agreement is a “forward contract” or whether a

party is a “forward contract merchant” relies on definitions contained in the Bankruptcy Code,

the inclusion of a forward contract representation in trading agreements reinforces the parties’

intended rights upon any bankruptcy. Moreover, by including such representations, each party to

the agreement is more likely to confirm that (i) the agreement qualifies as a “forward contract”;

and (ii) such party qualifies as a “forward contract merchant”, thus mitigating the risk that the

contractual rights of the parties are not protected under the Bankruptcy Code.

225

11 U.S.C.A. §§ 362(b)(6), 556 (addressing exemption of forward contracts and rights of forward contract

merchants); see Enochs and de la Pena, supra note 39, at 6-7.

5238158v.2