FAILURE TO DELIVER OR RECEIVE THE COMMODITY Cover, Take or Pay Issues, Netting and Offset Principles in Oil and Gas Transactions

Transcription

1 FAILURE TO DELIVER OR RECEIVE THE COMMODITY Cover, Take or Pay Issues, Netting and Offset Principles in Oil and Gas Transactions Craig Enochs, Esq., Houston Jackson Walker Justice Craig T. Enoch, Austin Winstead PC Carl Myers, Esq., Austin Winstead PC University of Houston Law Center Oil, Gas and Energy Law Conference September 20 21, 2007

2 Table of Contents I. SCOPE OF ARTICLE... 1 II. III. IV. "COVER" UNDER THE TEXAS BUSINESS AND COMMERCE CODE... 1 SELLER'S REMEDIES FOR BUYER'S FAILURE TO PURCHASE THE COMMODITY "TAKE OR PAY"... 5 REMEDIES UNDER THE NAESB BASE CONTRACT FOR SALE/PURCHASE OF NATURAL GAS... 8 V. NETTING AND OFFSET PRINCIPLES VI. CONCLUSION

3 I. SCOPE OF ARTICLE This article discusses the basic principles of cover, take-or-pay clauses, and netting and offset in Texas oil and gas law. It is by no means intended to be comprehensive, but rather to give practitioners a broad understanding of these concepts and their continuing implications. The body of the state's case law concerning oil and gas law is as rich and vast (and sometimes as murky) as the reserves beneath it; the goal of this article is to generally chart the legal principles implicated by a party's failure to supply or purchase the contracted-for commodity. II. "COVER" UNDER THE TEXAS BUSINESS AND COMMERCE Section is Article 2 s primary avenue of recourse for a buyer who attempts to minimize the damages suffered as a result of the seller s breach by obtaining substitute goods or commodities. 1 This section provides for the cover standard of calculating damages in the event of any breach by the seller. 2 The primary purpose of Section is to provide the buyer with a remedy that enables him to obtain the goods or commodities he needs, thus allowing him to continue to run his business regardless of whether the seller performs under the contract. In comparison to the seller s remedies, this remedy is the buyer s equivalent of the seller s right to resell. 3 Subsection (a) provides that upon the seller s breach, the buyer may effect cover by promptly purchasing substitute goods on commercially reasonable terms. 4 Texas law requires that in order to be entitled to cover damages under this section, a plaintiff must plead and prove that the goods or commodity were either not delivered at all or were non-conforming in such a way that the value of the non-conforming or undelivered products was substantially impaired. 5 This subsection has generated substantial litigation regarding whether the cover obtained by the buyer was reasonable within the meaning of the statute. 6 Texas courts have held that the test of proper cover is whether at the time and place the buyer acted in good faith 1 TEX. BUS. & COM. C (stating (a) After a breach within the preceding section the buyer may cover by making in good faith and without unreasonable delay any reasonable purchase of or contract to purchase goods in substitution for those due from the seller; (b) The buyer may recover from the seller as damages the difference between the cost of cover and the contract price together with any incidental or consequential damages as hereinafter defined (Section 2.715), but less expenses saved in consequence of the seller s breach; (c) Failure of the buyer to effect cover within this section does not bar him from any other remedy ); see also Aztec Corp. v. Tubular Steel,Inc., 758 S.W.2d 793, (Tex. App. -- Houston [14th Dist.] 1988) (stating that [d]amages may exceed the price paid upon findings by the jury of cost of cover exceeding contract price and by findings of incidental or consequential damages ). 2 TEX. BUS. COM. C ; Manon v. Tejas Toyota, Inc., 162 S.W.3d 743, 747 (Tex. App.-- Houston [14th Dist.] 2005). 3 TEX. BUS. COM. C , cmt TEX. BUS. COM. C (a). 5 Manon v. Tejas Toyota, Inc., 162 S.W.3d 743, 747 (Tex. App.--Houston [14th Dist.] 2005, no pet.) (finding that in order for the value of a good to be substantially impaired, the good or commodity must not be capable of its intended use by the party). 6 See, e.g., id.; Equitable Res. Marketing Co. v. U.S. Gas Transp., Inc., 2001 WL (Tex. App. Dallas 2001). -1-

4 and in a reasonable manner. 7 Courts also require that the type of substitute goods acquired by the buyer must be a reasonable substitute for the undelivered or non-conforming goods. 8 The crucial time for determining the reasonableness of cover is the time at which the buyer learns of the breach; therefore, it is immaterial that hindsight may later prove that the method of cover used was not the cheapest or most effective. 9 Courts have also held that the buyer must act to procure substitute goods without unreasonable delay. 10 However, the requirement that the buyer cover without unreasonable delay does not act as a strict limit on the time the buyer may take to examine the situation and available remedies, and determine the best method of effecting cover. 11 Article 2 presumes that the cost of cover will approximate the market price of the undelivered goods. 12 Therefore, the U.C.C. presumes that the cover procured by the buyer, and the price paid for it, is proper. The burden, therefore, is on the seller to show otherwise; however, the presumption of propriety and reasonableness arises only when the buyer proves that it has complied with the requirements of Section This burden does not, however, require the buyer to show the market price at the time of the breach, unless the reasonableness of the price paid for the substitute goods is called into question. Section 2.712(b) provides that if the buyer is able to purchase substitute goods, the buyer may then recover from the seller the difference between the cost of cover and the contract price, together with any incidental or consequential damages, but less expenses saved in consequence of the seller s breach. Subsection (c) provides that the buyer may cover at its option; the wronged buyer may cover as a means of minimizing damages, but his failure to effect cover does not bar him from any other remedy. Neither this Section 2.712(c), nor any other Code provision, actually requires the buyer to purchase or attempt to purchase substitute goods in the event of a breach by the seller; the buyer may elect not to cover and still sue the seller for damages, including any consequential damages incurred as a result of the breach. However, the buyer s recovery of consequential damages will be limited to those damages that could not have been prevented had substitute goods been obtained. 14 Therefore, the buyer is always free to choose between damages based on the difference between the contract price and the cost of cover under Section 2.712, and damages for non-delivery under Section 2.713, which consist of the difference between the market price at the time when the buyer learns of the breach and the contract price Aquamarine Associates v. Burton Shipyard, Inc., 645 S.W.2d 477, 480 (Tex. App. 9 Dist., 1982) (citing Teenan v. Jurek, 215 N.W.2d 698, 702 (Minn. Sup. 1977)). 8 Mueller v. McGill, 870 S.W.2d 673, 675 (Tex. App. Houston [1st Dist.] 1994) (discussing whether a 1986 automobile was a reasonable substitute for a 1985 automobile). 9 TEX. BUS. COM. C , cmt. 2; 2.713, cmt. 1 (discussing the buyer s damages for non-delivery or repudiation in the event that the buyer does not choose to cover, and stating that the crucial time is the time at which the buyer learns of the breach ); see also Jon-T Farms, Inc. v. Goodpasture, Inc., 554 S.W.2d 743, (Tex. Civ. App. 1977, rev d on other grounds) (discussing the time at which the buyer discovers the breach). 10 Mueller, at ; Aquamarine, at TEX. BUS. COM. C , cmt Kiser v. Lemco Indus., Inc., 536 S.W.2d 585, 589 (Tex. Civ. App. Amarillo 1976, no writ). 13 Id. 14 TEX. BUS. COM. C , cmt Id. -2-

5 Section outlines the buyer s primary recourse against the seller in cases in which the buyer does not cover and obtain substitute goods. 16 Subsection (a) provides that the buyer s measure of damages when the buyer does not cover is the difference between the market price at the time the buyer learned of the breach and the contract price, plus any incidental and consequential damages, but less any expenses saved as a result of the breach. 17 Subsection (b) requires that, in the event of complete non-delivery, the market price be determined as of the place for tender or, in the event that non-conforming goods are delivered, as of the place of arrival. 18 As discussed above, Article 2 assumes that the cover obtained, and the amount paid for it, is proper; therefore, under Section 2.713, [t]he general baseline uses as a yardstick the market in which the buyer would have obtained cover had he sought that relief. 19 The market price to be used in calculating damages under this section is the price for goods of the same kind and in the same branch of trade. 20 However, determining the applicable market price is not as simple as it may appear at first glance; parties attempts to determine the applicable market price has led to substantial litigation in many industries. Making this determination in the energy industry can be particularly problematic, because of the volatile nature of commodity prices, and the use of different internally calculated price curves to determine the market price. In effort to alleviate the difficulty in determining market price, Article 2 specifically provides for reference to the market price of a comparable commodity, or, more commonly, of the same commodity in a comparable market. Section 2.723(b) sets forth the acceptable method of proving market price in such a situation. 21 Where determining the market price at the time of breach is difficult, the parties may reference the prevailing price for the commodity at any reasonable time either before or after the breach or at any other commercially reasonable location. 22 Article 2 also specifically contemplates reference to the applicable spot sales price when no market price is available. 23 When the market price is unavailable because of the scarcity of the good or commodity, opinion evidence regarding the value of the goods or 16 TEX. BUS. COM. C (stating (a) Subject to the provisions of this chapter with respect to proof of market price (Section 2.723), the measure of damages for non-delivery or repudiation by the seller is the difference between the market price at the time when the buyer learned of the breach and the contract price together with any incidental and consequential damages provided in this chapter (Section 2.715), but less expenses saved in consequence of the seller s breach; (b) Market price is to be determined as of the place for tender or, in cases of rejection after arrival or revocation of acceptance, as of the place of arrival; (c) Evidence of a relevant price prevailing at a time or place other than the one described in this chapter offered by one party is not admissible unless and until he has given to the other party such notice as the court finds sufficient to prevent unfair surprise. ). 17 TEX. BUS. COM. C (a). 18 TEX. BUS. COM. C (b). 19 TEX. BUS. COM. C , cmt TEX. BUS. COM. C , cmt TEX. BUS. COM. C (stating (b) If evidence of a price prevailing at the times or places described in this chapter is not readily available the price prevailing within any reasonable time before or after the time described or at any other place which in commercial judgment or under usage of trade would serve as a reasonable substitute for the one described may be used, making any proper allowance for the cost of transporting the goods to or from such other place ). 22 TEX. BUS. COM. C (b). 23 TEX. BUS. COM. C , cmt

6 commodity is admissible. 24 In such a situation, a liberal construction of allowable consequential damages should also result. 25 Section sets forth the method by which a buyer who has accepted non-conforming goods may recover damages. 26 Generally, this remedy will be applicable only in cases in which the time for revocation of acceptance has passed. 27 However, the remedy of Section is available not only in the event of a breach of warranty by the seller (i.e. the delivery of nonconforming goods), but also in the event of any failure of the seller to perform his obligations under the contract. 28 This section is somewhat unique, as it provides that the buyer may recover in damages any loss resulting in the ordinary course of events from the seller s breach, as determined in any manner which is reasonable. 29 A buyer who elects to pursue a remedy under this subsection (a) must, however, strictly comply with its notice requirements. 30 This section also offers an additional remedy for a buyer who may still owe part of the purchase price. 31 Further, subsection (b) describes the usual measure of damages for a breach of warranty by the seller, which is measured as the difference at the time and place of acceptance between the value of the goods accepted and the value the goods would have had if they had been as warranted. 32 This subsection does, however, contemplate that special circumstances may warrant a recovery by the buyer of an amount of damages different from that calculated under the usual method outlined in subsection (b). Section describes the method of calculating incidental and consequential damages available under Sections 2.712, 2.713, and This section is intended to reimburse the 24 Id. 25 Id. 26 TEX. BUS. COM. C (stating (a) Where the buyer has accepted goods and given notification he may recover as damages for any non-conformity of tender the loss resulting in the ordinary course of events from the seller s breach as determined in any manner which is reasonable; (b) The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount; (c) In a proper case any incidental and consequential damages under the next section may also be recovered. ). 27 See TEX. BUS. COM. C , cmt TEX. BUS. COM. C , cmt TEX. BUS. COM. C (a). 30 The notice requirements under this subsection reference Section requires that when a buyer has initially accepted goods, the buyer must notify the seller of the breach within a reasonable time after the buyer discovers, or should have discovered, the breach; failure to give such notice will bar the buyer from recovering under any remedy. Section also states that a buyer cannot later reject goods if, at the time of acceptance, the buyer had knowledge of the non-conformity, unless the buyer accepted on the reasonable assumption that the nonconformity would seasonably be cured. 31 The primary remedy for a buyer who still owes is under 2.717, which allows the buyer to deduct all or any part of damages resulting from any breach of the contract from any part of the price still due under the same contract. See also 2.714, cmt. 1 (stating that the ability of a buyer to deduct damages from the price owed is an additional remedy for a buyer who still owes part of the purchase price). 32 TEX. BUS. COM. C (b). 33 TEX. BUS. COM. C (stating that (a) Incidental damages resulting from the seller s breach include expenses reasonably incurred in the inspection, receipt, transportation and care and custody of good rightfully rejected, any commercially reasonable charges, expenses or commissions in connection with effecting cover and any other reasonable expense incident to the delay or other breach; (b) Consequential damages resulting from the seller s breach include: (1) any loss resulting from general or particular requirements and needs of which the seller at the -4-

7 buyer who incurs reasonable expenses in connection with rightfully rejected goods or in connection with effecting cover where the seller breached by delivering non-conforming goods, or none at all. 34 Article 2 defines incidental damages resulting from the seller s breach as those expenses reasonably incurred in the inspection, receipt, transportation, care and custody of goods rightfully rejected, together with any commercially reasonable expenses incurred in effecting cover. The buyer s incidental damages also may include any other reasonable expenses incident to any delay or other breach by the seller. 35 Section 2.715(b) allows the buyer to recover consequential damages resulting from the seller s breach. However, the standard tacit agreement test is rejected by Article 2 in this section. The general common-law approach to consequential damages made the breaching party liable for all such damages of which he knew or had reason to know of prior to the breach. The approach taken by Article 2 in this section limits the buyer s recovery of consequential damages to only those damages the buyer could not reasonably have prevented through effecting cover or otherwise. 36 In order to charge the seller with knowledge sufficient to enable the buyer to recover consequential damages, any particular needs of a buyer must generally be made known to the seller, while general needs must rarely be made explicitly known in order to charge the seller with knowledge. 37 The burden of proving the extent of the loss incurred as consequential damages is on the buyer, but loss may be determined in any manner that is considered reasonable under the circumstances. 38 III. "TAKE OR PAY" PROVISIONS "Take or Pay" provisions require a party to purchase a stated minimum quantity of oil or gas or pay the difference between the quantity actually taken and the stated minimum quantity. 39 These provisions require a party to commit to purchasing that minimum quantity even if it would not be profitable to do so. While the principles of take-or-pay provisions apply equally to oil, it was the dramatically reduced demand for natural gas of the mid-1980's that resulted in significant litigation of these provisions. The Texas Supreme Court treated the issue in detail in Lenape Resources Corp. v. Tennessee Pipeline Co., 925 S.W.2d 565 (Tex. 1996). Tennessee Pipeline Company had signed a general purchase agreement in 1979 with Lenape's predecessor-ininterest. 40 Tennessee's goal in that agreement was to "obtain as much gas as could be produced from the committed reserves." 41 The agreement specifically disclaimed any corresponding obligations for Lenape to deliver any particular quantity of gas or maintain any particular level of deliverability which was fortunate for Lenape, as the committed acreage produced only two time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise; and (2) injury to person or property proximately resulting from any breach of warranty. ) 34 TEX. BUS. COM. C , cmt TEX. BUS. COM. C (a). 36 TEX. BUS. COM. C , cmt TEX. BUS. COM. C , cmt TEX. BUS. COM. C , cmt El Paso Natural Gas Co. v. Minco Oil & Gas, (Tex. 1998). 40 Id. at Id. -5-

8 wells before 1989, and one was a low-producing stripper well. 42 In the early eighties, Tennessee notified Lenape and other producers of its "emergency gas purchase policy," by which it intended to limit its gas purchases and reduce its take-or-pay obligations or refuse to recognize any take-or-pay obligations for producers who refused to amend. 43 When a subsequent attempt to amend was unsuccessful, Tennessee asserted the force majeure provision of the agreement based on the dramatic change in market conditions. 44 Lenape's lessors sued Lenape for failing to develop the leases in spite of the questionable market. 45 In settlement, Lenape agreed to combine part of the committed acreage with adjacent property. 46 Other parties (Tesoro and Coastal Oil Corporation) proceeded, under a farmout agreement, to develop the leases. 47 For Tennessee, what happened next was a disaster two of three wells were very, very successful. While the wells would have seemed a boon in 1979 when the agreement was inked, the new wells would "vastly" increase Tennessee's take-or-pay obligations. Tennessee filed suit, asserting numerous theories to escape the take-or-pay provisions of its contract. The Justices of the Texas Supreme Court joined in discounting several of Tennessee's defenses: the pricing references used by the court below were correct; the buyer could not rely on the period of non-productivity to assert the seller's right to terminate a lease; and the pooling the acreage was permitted under the terms of the parties' 1979 contract. The Court split 5-4, however, on the question of whether the take-or-pay obligation in the contract was an output contract subject to Section of the UCC. Tennessee argued that Section governed the contract. That section provides: [a] term which measures the quantity by the output of the seller or the requirements of the buyer means such actual output or requirements as may occur in good faith, except that no quantity unreasonably disproportionate to any stated estimate or in the absence of a stated estimated to any normal or otherwise comparable prior output or requirements may be tendered or demanded. Because the contract bound Tennessee to purchase whatever gas was produced by the Lenape wells, Tennessee argued that it was an output contract under the UCC. Accordingly, the dramatic increase in the amount of gas produced from the new wells was "in bad faith" and "disproportionate to" the leases' prior production. The question of whether take-or-pay provisions constituted output contracts subject to Section was one of first impression for the Court. Four of the justices, in fact, held that the contract did constitute an output contract, referencing two prior decisions in other circuits reaching that conclusion Id. 43 Id. 44 Id. 45 Id. 46 Id. 47 Id. 48 Id. at 578, citing United States v. Great Plains Gasification Assoc., 819 F.2d 831, 834 (8th Cir.1987) and American Exploration Co. v. Columbia Gas Transmission Corp., 779 F.2d 310, 311 (6th Cir.1985). -6-

9 The majority upheld the enforceability of the take-or-pay provision, finding it was not an output contract, but even if it were, Section would not apply. 49 An output contract is a commitment to buy the seller's entire production. A take-or-pay obligation, in contrast, gives the purchaser the right to either purchase the commodity or pay the producer for the right to purchase that gas in the future. 50 Based on this alternative performance, the majority held that the take-or-pay provision was not a sale but "payment for the exclusive dedication of reserves for a fixed period of time." 51 Notably, the amount of gas actually produced depends entirely on the buyer in such an arrangement; if the buyer does not take the gas, there is no output produced at all. Even if a take-or-pay provision did constitute an output contract, however, the majority concluded that Section would not apply. 52 That section is a UCC "gap-filler," and it does not apply when a contract specifies either the quantity or a numeric standard for determining the specific quantity. 53 There was a numeric standard under the parties' contract: a set, defined percentage of delivery capacity, an objectively measurable amount. 54 Because the amount called for under the contract could be determined by a simple mathematical formula, there was no need to rely on the gap-filler provision. The majority opinion discounted Tennessee's arguments that this interpretation would somehow escape the "good faith" requirements of the Texas Business and Commerce Code a seller is entitled under a take-or-pay provision to make good-faith increases to its delivery capacity. 55 Holding otherwise would inject uncertainty into an otherwise definite agreement: The quantity of gas which [the buyer] must either take or pay for would depend on a number of indeterminate variables: prior output; normal prior output; comparable prior output; proportionality to either normal or comparable prior output; and reasonableness of the proportionality. Reading these factors into [buyers'] take-or-pay obligations, any increase in production and delivery capacity would be measured after the fact by these variables, thus injecting uncertainty into the parties' obligations Noting the intention of the parties in 1979 when the contract was executed, specifically the seller's right to unilaterally drill more wells, unitize leases, and otherwise increase production, the Court fully enforced the take-or-pay provision despite the fact that the buyer now regretted its exclusive purchase rights in the commodity. 49 Id. at Id. 51 Id. 52 Id. at Id. 54 Id. at Id. at

10 The lack of "good faith and fair dealing" does not invalidate release of take-or-pay obligations. Buying and selling oil or gas pursuant to take-or-pay purchase agreements is a transaction involving "goods," implicating the UCC's good faith provisions. 56 Accordingly, parties have a statutory obligation to act in good faith in the performance, enforcement and modification of these agreements. 57 But that does not mean that a party is under a statutory good faith obligation when it procures or forms those contracts. 58 Accordingly, as the Texas Supreme Court held in Minco, a party cannot escape a release of a buyer's take-or-pay obligations based on the heavy-handedness of the buyer. Royalty interests in Take-or-Pay Settlements. One area that is not explored in detail in this paper is the considerable volume of litigation by lessors who attempted to share in the settlement proceeds of the producers who leased from them. A plethora of legal theories were advanced in support of the proposition that lessors were entitled to share in those proceeds, ranging from the implied duty to market to the duty of good faith and fair dealing. In Texas, at least, the prospects of a lessor for sharing in those proceeds are fairly stark. The Fifth Circuit (in a 1988 opinion cited by the Texas Supreme Court in Lenape) held that "[n]o royalty is due on take-or-pay payments unless and until gas is actually produced and taken." 59 Subsequent Texas decisions generally share the conclusion that royalty owners do not benefit from take-or-pay provisions at least until the commodity is produced. 60 Those courts frequently rely on the Texas Supreme Court's decision in Lenape, which characterized take-or-pay payments as compensation for the exclusive dedication of reserves to a contract, "not a payment for the sale of gas." 61 In the final decades of the last century, take-or-pay issues based on pre-1980 contracts spawned a huge volume of litigation and contractual wrangling. While prices have since stabilized, the potential application has moved to other areas, like electricity. As companies invest in the infrastructure these new fields require, they are understandably eager to secure longterm sales contracts. Electricity and other energy commodities may give rise to the next generation of take-or-pay issues. IV. NAESB BASE CONTRACT FOR SALE AND PURCHASE OF NATURAL GAS The North American Energy Standards Board Base Contract for Sale and Purchase of Natural Gas (the NAESB ) is the master agreement most commonly used to document natural gas transactions. The NAESB provides specific remedies for a failure to deliver or receive gas and upon the occurrence of Events of Default. The NAESB also contains specific provisions granting the parties the right to demand adequate assurances of performance and provides a remedy to the demanding party if the other party fails to comply with a proper request for assurances. 56 El Paso Natural Gas Co. v. Minco Oil & Gas, Inc., 8 S.W.3d 309 (Tex. 1999). 57 Id. at Id. 59 Diamond Shamrock Exploration Co. v. Hodel, 853 F.2d 1159, 1168 (5 th Cir. 1988). 60 See, e.g., TransAmerican Natural Gas Corp. v. Finkelstein, 933 S.W.2d 591 (Tex.App. San Antonio 1996, writ den.); Alameda Corp. v. TransAmerican Natural Gas Corp., 950 S.W.2d 93 (Tex.App. Houston [14 th Dist.] 1997, writ den.). 61 Lenape, 925 S.W.2d at

11 A. Failure to Deliver or Receive Gas Section 3.2 of the NAESB provides for liquidated damages in the event the seller fails to deliver, or the buyer fails to receive, quantities of gas agreed to in a transaction. The NAESB requires the parties to elect to use either the cover standard or the spot price standard for calculating liquidated damages. 62 Once a remedy is selected, that remedy becomes the exclusive remedy in the event of a breach of an obligation to deliver or receive gas. 63 The Cover Standard is defined by the NAESB to require the non-breaching party to use commercially reasonable efforts to either obtain gas or an alternate fuel, or sell gas, at a price that is reasonable for the delivery point or production area. 64 The price paid or received by the non-breaching party attempting to effect cover in this manner is the price that will be used to calculate any payment due under Section 3.2. Under this Cover Standard, the reasonableness of the price received or paid for gas may be affected by several factors, including (1) the amount of notice provided by the nonperforming party; (2) the immediacy of the buyer s consumption needs or the seller s sales requirements; (3) the quantities involved; and (4) the anticipated length of failure by the breaching party. 65 Section 3.2 sets forth the Cover Standard for calculating damages. 66 Under this 62 NAESB See NAESB 3.2; see also 2.17 (stating that Firm shall mean that either party may interrupt its performance without liability only to the extent that such performance is prevented by reasons of Force Majeure; provided however that during Force Majeure interruptions, the party invoking Force Majeure may be responsible for any Imbalance Charges as set forth in Section 4.3 related to its interruption after the nomination is made to the Transporter and until the change in deliveries and/or receipts is confirmed by the Transporter ). 64 NAESB 2.9 (providing that Cover Standard shall mean that if there is an unexcused failure to take or deliver any quantity of Gas pursuant to this Contract, then the performing party shall use commercially reasonable efforts to (i) if Buyer is the performing party, obtain Gas (or an alternate fuel if elected by Buyer and Gas is not available), or (ii) if Seller is the performing party, sell Gas, in either case, at a price reasonable for the delivery or production area, as applicable, consistent with: the amount of notice provided by the nonperforming party; the immediacy of the Buyer s Gas consumption needs or Seller s Gas sales requirements, as applicable; the quantities involved; and the anticipated length of failure by the nonperforming party ). 65 NAESB NAESB 3.2 (defining Cover Standard as [t]he sole and exclusive remedy of the parties in the event of a breach of a Firm obligation to deliver or receive Gas shall be recovery of the following: (i) in the event of a breach by Seller on any Day(s), payment by Seller to Buyer in an amount equal to the positive difference, if any, between the purchase price paid by buyer utilizing the Cover Standard and the Contract Price, adjusted for commercially reasonable differences in transportation costs to or from the Delivery Point(s), multiplied by the difference between the Contract Quantity and the quantity actually delivered by Seller for such Day(s); 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); or (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, then the sole and exclusive remedy of the performing party shall be any unfavorable difference between the Contract Price and the Spot Price, adjusted for such transportation to the applicable Deliver Point, multiplied by the difference between the Contract Quantity and the quantity actually delivered by Seller and received by Buyer for such Day(s). Imbalance Charges shall not be recovered under this Section 3.2, but Seller and/or Buyer shall be responsible for Imbalance Charges, if any, as provided in Section 4.3. The amount of such unfavorable difference shall be payable five -9-

12 section, if the seller fails to deliver the gas as required by the contract, the seller must pay to the buyer the difference between the purchase price paid by the buyer utilizing the Cover Standard and the Contract Price. 67 Similarly, if the buyer fails to receive the gas as required by the contract, the seller is entitled to the difference between the Contract Price and the price received by the seller utilizing the Cover Standard. 68 The damages calculated pursuant to this method will, in both instances, be adjusted for commercially reasonable differences in transportation costs to or from the delivery points, and for the percentage of the contracted-for quantity gas actually taken by the buyer or delivered by the seller. 69 The Spot Price Standard, offered as an alternative to the Cover Standard, sets forth a materially different method of calculating damages. 70 If a party fails to take or receive gas as required by a transaction, the non-performing party must pay to the performing party the difference between the Contract Price and the Spot Price. Spot Price is defined as the price listed in the publication indicated on the Base Contract for the geographic location in closest proximity to the delivery points for the relevant days. 71 Additionally, both standards provide that all charges assessed using either standard must be paid five business days after the presentation of the performing party s invoice setting forth the basis upon which such amount was calculated. 72 The NAESB allows the parties to elect an alternative measure of damages if they are unsatisfied with the option offered by either the Cover Standard or the Spot Price Standard. Alternative Damages are defined as any measure or amount of damages agreed upon by the parties in a Transaction Confirmation. 73 Alternative Damages may be used only when the parties Business Days after presentation of the performing party s invoice, which shall set forth the basis upon which such amount was calculated. ). 67 Id. 68 Id. 69 Id. 70 NAESB 3.2 (defining Spot Price Standard as [t]he sole and exclusive remedy of the parties in the event of a breach of a Firm obligation to deliver or receive Gas shall be recovery of the following: (i) in the event of a breach by Seller on any Day(s), payment by Seller to Buyer in an amount equal to the difference between the Contract Quantity and the actual quantity delivered by Seller and received by buyer for such Day(s), multiplied by the positive difference, if any, obtained by subtracting the Contract Price from the Spot Price; or (ii) in the event of a breach by Buyer on any Day(s), payment by Buyer to Seller in an amount equal to the difference between the Contract Quantity and the actual quantity delivered by Seller and received by Buyer for such Day(s), multiplied by the positive difference, if any, obtained by subtracting the applicable Spot Price from the Contract Price. Imbalance Charges shall not be recovered under this Section 3.2, but Seller and/or Buyer shall be responsible for imbalance Charges, if any, as provided in Section 4.3. The amount of such unfavorable difference shall be payable five Business Days after presentation of the performing party s invoice, which shall set forth the basis upon which such amount was calculated. ). 71 NAESB This section refers to the price listed in the publication indicated on the Base Contract; thus, if the parties choose the Spot Price Standard for calculating damages, the parties must then select a reliable market publication that will allow them to determine the spot price on any given day. This section also provides that if there is no single spot price published for a particular location on a particular day, but there is a published range of prices, then the spot price will be the average of the highest and lowest prices listed. If there is no range of prices published, then the spot price will be the average of (1) the price for the first day for which a price or range of prices is published that next precedes the day(s) of the breach, and (2) the price for the first day for which a price or range of prices is published after the day of the breach. 72 NAESB NAESB

13 have expressly agreed to their use in a written transaction confirmation executed by both parties. 74 The NAESB requires the parties to make commercially reasonable efforts to buy or sell gas before the aggrieved party will be entitled to damages for any failure to take or deliver. 75 The NAESB also requires that the performing party s efforts to obtain cover in this respect be commercially reasonable. In addition to the commercially reasonable requirement, the NAESB allows the non-breaching party, when assessing the reasonableness of the price of cover, to take into account not only the time and place for tender, but also the amount of notice provided by the nonperforming party, the immediacy of the buyer s consumption needs or the seller s sales requirements, the quantities involved, and the anticipated length of failure by the nonperforming party. 76 Notably, both the Cover Standard and the Spot Price Standard expressly address the payment of imbalance charges and provide that such charges will be paid by the party whose act or omission caused such charges to be imposed. 77 The NAESB also requires that any amount owed for failure to deliver or accept must be paid within five business days after receipt of an invoice detailing the manner in which any damages were calculated. These remedy elections differ in scope from those offered in the U.C.C. First, unlike the NAESB, the U.C.C. applies the perfect tender rule, which labels any failure by either party to deliver or receive goods in perfect conformity with the terms of the contract as a breach. 78 Under the U.C.C., any breach gives the non-breaching party the right to exercise certain remedies, and, in certain circumstances, terminate the contract. The NAESB, like most energy commodity contracts, does not apply the perfect tender rule, but instead lists certain Events of Default, the occurrence of which gives the performing party the right to suspend its performance and/or terminate the contract. Not every failure to comply with the obligations of the contract constitutes an Event of Default. Most notably, perhaps, is that the failure to deliver or receive the quantity of a commodity identified by the contract does not constitute an Event of Default under the NAESB; the NAESB simply sets forth a method of calculating the payment that must be made to the performing party in the event the counterparty fails to delver or receive the requisite amount of gas. Under the U.C.C., upon a failure by the buyer to receive gas, the seller may be entitled to suspend further deliveries, resell the gas not received by buyer and recover costs and incidental damages associated with the resale, and, if the rejection goes to the whole contract, terminate the contract. 79 Upon the failure by the seller to deliver gas, the buyer may be entitled to cancel the contract if the seller s failure goes to the whole contract, and/or cover 74 NAESB NAESB NAESB NAESB 4.3 (providing that [t]he parties shall use commercially reasonable efforts to avoid the imposition of Imbalance Charges. If Buyer or Seller receives an invoice from a Transporter that includes imbalance charges, the parties shall determine the validity as well as the cause of such Imbalance Charges. If the Imbalance Charges were incurred as a result of Buyer s receipt of quantities of Gas greater than or less than the Scheduled Gas, then Buyer shall pay for such Imbalance Charges or reimburse Seller for such Imbalance charges paid by Seller. If the Imbalance Charges were incurred as a result of Seller s deliver of quantities of Gas greater than or less than the Scheduled Gas, then Seller shall pay for such Imbalance Charges or reimburse buyer for such Imbalance Charges paid by Buyer ). 78 TEX. BUS. COM. C ; TEX. BUS. COM. C ; 2.612;

14 damages or specific performance of seller s obligations. 80 The NAESB requires both seller and buyer to sacrifice the opportunity to exercise powerful remedies in exchange for the certainty that their liability will be limited to cover damages and costs. The NAESB also requires the parties to make commercially reasonable efforts to buy or sell gas before the aggrieved party will be entitled to damages for any failure to take or deliver; the Code, however, does not require the non-breaching party to attempt to mitigate its damages before being entitled to exercise any remedy. The Code merely limits the nonbreaching party s recovery of consequential damages in the event the party fails to cover. 81 V. NETTING AND OFFSET FUNDAMENTALS Netting and setoff are often used interchangeably but, as used in energy transactions, usually refer to provisions that function differently to address different needs of the parties. Netting and setoff provide valuable rights to parties that take care to include these provisions in their energy agreements. Netting increases the efficiency of the contract s operation, and setoff is a valuable shield to ensure parties are not obligated to pay amounts to a counterparty without receiving amounts owed by the counterparty in return. These rights vary greatly across jurisdictions, and often require additional elements to be met in order for the rights to be preserved. As a result, parties are best protected by negotiating netting and setoff rights into the contract and tailoring these provisions to the choice of law elected in the contract. In all cases, parties should exercise caution and consult with counsel to ensure their setoff rights are preserved under applicable law. A. Netting Netting means that all transactions under the agreement are netted down to one financial amount so that at all times one amount is owed by one party to the other, to make settlement of payments easier and to minimize credit risk. 82 In the context of energy commodity contracts, the term is usually used to describe the regular netting in each invoice period of amounts owing between the parties, to simplify the credit exposure of the party owed the net amount and to increase the efficiency of the invoicing process. Netting is an important element in most energy transactions that anticipate ongoing, recurring, bilateral payment obligations because of the convenience it provides. It allows for the more efficient processing of amounts owed on a regular basis. Absent netting, amounts owing between the parties to a contract on the same date would be invoiced separately by each party and each party would make a payment to the other party under its respective invoice. When the parties settle invoices using netting, only the party owed the greater amount issues the invoice and only the party owing the net amount makes payment, thus reducing the number of invoices 80 TEX. BUS. COM. C ; 2.711; See TEX. BUS. COM. C (c). 82 Mark E. Haedicke & Alan B. Aronowitz, GAS COMMODITY MARKETS, in 4 Energy L. & Transactions (David J. Muchow & William A. Mogel eds., 2001). -12-

15 issued and payments made by half. By permitting the parties to exchange only one invoice each month showing all amounts owing between the parties and requiring only the net amount owed to be paid, the parties avoid the additional work and expense of generating and processing an extra invoice and making a second payment, thereby increasing the efficiency of the parties transactions. Netting is usually incorporated into contracts as a process that will occur regularly at the time each invoice is issued during the term of the contract, often commencing with a discussion between the parties several business days prior to the issuance of the invoice to verify that no disagreement exists with respect to the amounts owed. Example: Party A owes Party B $1,000,000 for natural gas in a month, and Party B owes Party A $250,000 for imbalance charges Party A incurred on Party B s behalf during that same month. On the seventh day of the month Party A and Party B discuss the charges and the net amount owed. On the tenth day of the month Party B effects netting and sends Party A an invoice for $750,000. The term netting is also sometimes used to refer to a physical offset of energy commodity volumes counterparties are scheduled to deliver to and receive from each other during the same time period. 83 The netting of physical volumes is economically efficient for the parties because it allows them to reduce transportation expenses and other costs by paying such costs only on the net delivered volumes. B. Setoff Example: Party A is scheduled to deliver 10,000 MMBtu of natural gas at a delivery point at a certain price on a given day, and Party B is scheduled to deliver 7,000 MMBtu to Party A at the same delivery point for the same price on the same day. The parties net these physical obligations with the result that Party A will deliver 3,000 MMBtu to Party B and Party B will not deliver any volumes to Party A. 1. Definition Setoff is defined as [a] debtor s right to reduce the amount of a debt by any sum the creditor owes to the debtor; the counterbalancing sum owed by the creditor. 84 Setoff modifies the parties obligations to each other by reducing the two separate gross amounts owed to a single, net owed amount. Its use is usually contemplated when a contract terminates, a party breaches the contract, and/or there is some other occurrence that would cause a party to believe that it will not be paid amounts owed to it by its counterparty. 2. Background Setoff originated as a common law remedy grounded on the absurdity of making A pay B when B owes A. 85 Setoff is important because, without an effective set-off clause, the Non- 83 This practice is also commonly referred to as a bookout of volumes. 84 BLACK S LAW DICTIONARY (2nd pocket ed. 2001). Also sometimes written as set-off or offset. 85 Studley v. Boylston Nat l Bank of Boston, 229 U.S. 523, 528 (1913). -13-

16 defaulting Party might be required to make payment to the Defaulting Party... upon termination while, at the same time, the Non-defaulting Party may not have any realistic expectation of receiving payments owed to it by the Defaulting Party (and its Affiliates) under other agreements. 86 The term setoff is usually used in energy commodity contracts to describe provisions that permit the offset of obligations between parties at the end of their contractual relationship, as opposed to netting, which usually describes a routine aggregation or offset of amounts owed between the parties each time an invoice is issued under an agreement. Setoff can be a common law right or a contractual right. 87 Contractual setoff is usually preferred because it eliminates the uncertainty of whether the necessary elements to use common law setoff have been met. In general, contractual setoff provisions are enforceable even if the requirements for common law setoff have not been met. 88 Setoff mitigates risk because, with respect to the obligations that are setoff: (i) it extinguishes the obligations without further action; (ii) it eliminates the non-defaulting party s credit risk for amounts it is owed by the defaulting party to the extent of the amounts setoff; (iii) it eliminates the non-defaulting party s cash flow risk while waiting for payments; and (iv) when the defaulting party is bankrupt, it allows the non-defaulting party to reduce its entanglement in bankruptcy proceedings and minimizes any payment the non-defaulting party must make to the insolvent counterparty. owed. (i) Setoff modifies the obligations of the parties and extinguishes the lesser amount Example: Party A terminates and liquidates a contract following Party B s default. The aggregate amount Party A owes Party B is $800,000 and the aggregate amount Party B owes Party A is $2,500,000. Party A sets off these amounts resulting in Party B owing Party A $1,700,000 and Party A owing Party B nothing. (ii) Setoff eliminates the credit risk associated with the setoff amounts. This allows the parties to calculate credit exposure assuming the setoff will be effected, resulting in more efficient utilization of credit support resources. Example: Party A and Party B are parties to a NAESB. On a given day Party A has mark-to-market exposure to Party B in the amount of $5,000,000. Party B has credit exposure for gas that has been delivered to, but not yet paid for by Party A in the amount of $650,000. In the event the contract were terminated and 86 User s Guide to the 1992 ISDA Master Agreements, Sec. V. 87 Blount v. Windley, 95 U.S. 173, (1877); Sherman v. First City Bank of Dallas, 99 BR 333, 336 (N.D. Tex. 1989); In re Bennett Funding Group, Inc., 146 F.3d 136, 140 (2d Cir. 1998); see also 3 Lafayette Ave. Corp. v. Comptroller of the State of New York, 587 N.Y.S.2d 456, 457 (N.Y. App. Div. 1992). New York has also created a statutory right to set off and apply against any indebtedness, whether matured or unmatured, of such creditor to such debtor, any amount owing from such debtor to such creditor, at or at any time after... the filing of a petition under any of the provisions of the federal bankruptcy act.... N.Y. DEBT. & CRED. LAW 51 (McKinney 2001). 88 Parker v. Moore Grocery Co., 107 S.W.2d 1083, 1085 (Tex.Civ.App.-Beaumont 1937, no writ). -14-