Long Term Take or Pay Contracts

“The most common disputes that project finance lawyers come across are over the terms and enforceability of long term take or pay contracts.” Discuss

Project finance [1] proceeds on the basic principle that limits the lender primarily to project revenues in order to service the project debt. Therefore it is a very important concern in the project credit analysis that the project is not only practicable but also that the revenue flows are predictable and assured. The predictability and assurance of the revenue flows from the project decreases the lenders concerns about the possible risk of non-payment of the project debt. This aspect strongly influences the lender’s judgement with regard to the bankability (i.e the acceptance) of the project structure.

The project lawyers need to understand the importance of taking security, either fixed or floating, over each and every asset imaginable, but they must also be familiar with how the underlying facility function and its ability to produce revenues for periods surmounting decades. Legal analysis is an important part of project finance due diligence effort. For instance technical advisers analyse the physical plant, while markets advisors work out the cost of inputs and the worth of the future income streams, and the auditors measure the reliability of the financial models. The lawyer works along with these other experts to recognize the risks involved and to produce an integrated due diligence report, which is often stated as being restricted to legal issues, but out of requirement often based greatly on contributions from a range of experts. Out of this procedure the parties are asked to give an assessment on the ‘bankability’ of a possible risk or of the project as a whole. The fact that no project is same should be very clear. Variables such as the heftiness of the underlying economics, often calculated with regard to the predictable debt service coverage ratios, the level of complication and dependability of the asset’s technology and constancy and lucidity of the host country’s legal and political atmosphere, decide how cooperative investors are likely to be with regard to legal and other risks.

Generally the legal issues which a project lawyer deals with encompass the law of contracts, property, trust, tort and equity. They must be capable of documenting the different requirements of a broad range of markets. In fact their skill must extend beyond finance papers. The most common dispute which the project lawyers face circulates around the terms and enforceability of long term ‘take or pay’ contracts. These contracts highlight mainly big projects. The sale of power of natural resources such as oil and gas, telecommunications capacity and a variety of other products normally fall under a contract in which the purchaser consent to take a minimum amount of output at a price which is based on a set formula for a specified period of time. Thus, the project company becomes contractually insulated, at least to a certain level, from the single thing which it can least control which is the long term market conditions. The minimum volume commitments can be specifically allowed by a fixed or floor price on those volumes.

The responsibility of the project finance lawyer is to try to bring some certainty in advance to this process by identifying the main risks and by getting the parties to agree who takes them long before they arise. They divert the parties’ thought on the worst case scenarios, which make them consider situations which none of them ever wishes to stumble upon. There is hardly any debate about the consequence of an act of God (mostly which is usually insured), but the debate may be heated, when the debate turns to measure who would take the risk, which arises out of an act of government, such as if the government imposes new tax law or introduces an import restriction, either of which might affect the fundamental economics of the deal. No party can easily assume the risk that is outside its control, and governments seldom assure parties that such risks will not come up, as they usually do not wish to restrain the discretion of their successors.

For energy projects varying from pipeline, to natural resources such as oil and gas, and LNG to power have been formed under long term contracts with their ‘take or pay provisions’ which have been the main means of assuring predictable cash flows. The lenders fear for predictable cash flows arise from the need to restrict its involvement in the project to only credit risks and to find support for the project loan and arrangements for its repayment within the market. The significance of long-term contracts to energy project economics is predicted on three factors. First it is the involvement of high capital for energy projects. Second is the long period of time (usually from 20 to 30 years) which gives the project sponsor adequate opportunities to earn back investments and attain repayment of project loan plus interest on lender. Third is the take or pay element. This element makes the offtaker/buyer either to take delivery of the prescribed minimum quantity of the offtake or to pay for the deficit. The term ‘take or pay’ is suitable in the context of an oil, gas or power project formation whilst the same effect is laid down in a pipeline project arrangement through ‘put or pay/ship or pay’ provisions.

An offtake contract is used for a project that produces a product (for instance a power purchase agreement is used for a project producing electricity). Such agreements provide the purchaser or the offtaker with a secure supply of the required product and the project company with the ability to sell its products on a pre-agreed basis. Offtake contracts can take various forms. One of which is the take or pay contract which provides that the offtaker must take the projects product or make a payment to the project company in lieu of purchase. The price for the offtaker e product is based on an agreed tariff. Such contracts are seldom on a ‘hell-or-high-water’ basis where the offtaker is always obligated to make payments whatever happens to the project company. The project company is only paid if it performs its side of the deal in general, if it is capable of delivering the product.

In case of long term sales contract the offtaker agrees to takes quantities of product from the project which have been agreed upon, but the price paid is based on market prices at the time of purchase or an agreed market index. The project company thus does not take the risk of demand for the projects product, but takes the market risk on the price. This type of contract is commonly used in, for example mining, gas and oil, and petrochemical projects, where the project company wants to ensure that its product can easily be sold in international markets, but offtakers would not be willing to take the commodity price risk. This type of contract may have a floor or minimum price for the commodity, as has been the case in some LNG projects- if so, the end result equates to a take-or-pay contract at this floor price and has the same effect as a hedging contract.

There are two legal considerations that contribute to the value of the project finance contracts to the lender and the project company as the essential credit support for a transaction. Since the effectiveness of the contract for both the project company and the lender depends upon enforceability, the basic principles of contract law must be applied. Furthermore if the transaction results in an economic difficulty the viability of the contract as collateral must be considered.

From the project company’s perception the project contracts are the foundation for project earnings and expenses. Likewise, from the lenders perception the relevant collateral of the project financing is the collection of contracts put up by the project company for the development, operation and construction of the project. Which are all very crucial factors in assessing the credit viability of the lender.

Each project finance contract is usually an executory contract: one of the participants of the project is yet to execute or finish executing for entitlement to the full benefits of the contract, and the other party is yet to pay in full for the goods or services. Executory contracts demonstrate unique risks to the project which have an effect on the value as collateral. The risk to the project finance lender is based on this excutory nature. Either the project company or the other contracting party (which is the obligor) will have performed any significant contractual obligation at the time of the closing of the project finance loan. Additionally ongoing performance obligation will continue throughout the life of the project since project finance contracts generally have duration of fifteen, twenty and as long as thirty years. Many excuses will exist to give the obligor defences to the requirement to carry out the contract, including any revenue payment due the project. For instance the obligor may have a defense to performance or payment that take place under the terms of the contract, or the obligor may have a right of setoff which arises independently of the project financing. Since each project contract takes place in a changing, non static environment the contract is subject to modification by formal amendment or waiver of rights or remedies. A project financing is thus distinguishable from accounts receivable financing: the collateral is subject to many problems that occur out of the executory nature and that get in the way with the ultimate collateral value.

The rights of a project company in a company are subject to the contract terms and many defences, claims and offsets. This makes the project finance lender face a many risks resulting from the project company’s contract performance, misconduct and the enforceability of the contract. In determining the risks and defences in a contract term, the discussion will focus on the effect of Uniform Commercial Code on various states of the United States.

One solution for the secured party would be to get consent to a ‘cutoff’ pursuant to U.C.C §§ 9-403 and 9-404 that the other contracting party will not make claims, defences or offsets against the secured party [2] . An agreement like this is unenforceable however where the secured party was aware of the defence but did not act in good faith [3] . Furthermore the contracting party would not be held to have waived the contractual defences which relate to capacity, such as fraud and lack of authority [4]

If a cutoff agreement cannot be attained or consent negotiated, the secured party can still gain by giving the other contracting party notice of the assignment. U.C.C § 9-404 provides the secured party with the capability to stop the other contracting party from raising defences or claims against the secured party that accrue after notice is given that are in regard to other transactions between the project company and the other contracting party. In addition to or as an alternate to an agreement with the obligor or notice to the obligor the lender will inspect the contracts for validity and enforceability. This due diligence investigation generally takes in the form of reviews and opinions by the counsel.

The common law doctrine of frustration of purpose eases an obligor of its duty to perform where a failure of some fundamental assumptions results in severe difficulty or expense. Thus changed circumstances under a project output sales agreement which render or frustrate the impracticability of a purchaser’s performance obligation could result in the avoidance of the agreement by the purchaser. The test is generally ‘whether the cost of performance has in fact turned so excessive and unreasonable that the failure to excuse performance would result in serious injustice’.

On the other hand, a project participant may keep away from performance of contractual obligation by use of the doctrine of commercial impracticability. The doctrine under U.C.C § 2-615 provides that the performance under a contract will be exempted if the party has not assumed the risk of some unknown contingency, the non-occurrence of the contingency had been a basic assumption underlying the contract, and the happening of the contingency had made the performance commercially impracticable. Section 2-615 is usually applied when an unforeseeable contingency has changed the main nature of the performance. U.C.C comment 4 states that if there is a serious shortage of raw materials or of supplies due to a contingency such as a war, embargo, local failure of crop, an unexpected shutdown of major sources of supply or something similar then that may entitle a party to get relief under § 2-615. However the section does not defend a party from its contractual obligations simply because of a rise or collapse in the market, because that is ‘the type of business risk that business contracts made at fixed prices are intended to cover’ [5] . Hence courts have refused to excuse the buyer from its performance simply because the resale market prices fell severely after the contract was executed.

Commercial impracticability and frustration of purpose are not the most important risks for the project participants. The nonrecourse limitation on debt repayment entail that project contracts contain comprehensive force majeure provisions in order to allocate risks connected with contract performance. Consequently, the project company may limit a project participant’s recourse to the doctrine of commercial impracticability by specifying in the contract the only contingencies that will excuse performance. Comment 8 to § 2-615 provides that the application of that section is subject to greater liability by agreement.

Other legal theories that can be cited to invalidate project contracts include mutual mistake about the basic assumptions of the transaction [6] and ‘unconscionability’ arising out of one-sidedness [7] . Additionally each contract is subject to the terms set forth in the contract for performance, including provisions such as the warranties and conditions. Hence, the court may give relief from unexpected commercial risks, in spite of the collateral impact on financing.

Long term contracts assist capital investment in big projects where returns accumulate over a long time. In energy projects, long term take or pay contracts ensures the lender predictable cash-flow. The duration for such long term contracts vary from 20 to 30 years. The thinking is that such long periods enhance the sponsor’s prospective to earn back their investments made in the project and to pay the projects debts. The take or pay factor guarantees that in any event the project will earn revenue. However there is a possibility for the buyer to incur substantial sunk costs where prepaid offtake is not recouped by the buyer before the expiry of the take or pay contracts. Generally long term contracts in addition to take or pay clause, also contains make-up or carry-forward conditions, which aid the buyer to average out the take or pay commitment over the life of the contract [8] . These provisions could also increase the potential for sunk costs for the buyer. This is because the buyer must recuperate the offtake amounts paid for but not taken throughout the life of the contract, or else they are forfeited.

In considering the enforceability of the long term take-or-pay contracts the impact of liberalisation also need to be discussed. Returns under long term contracts are often on the basis of long term demand and price projections. For example the amount of gas needed by a monopoly offtaker may fairly be simple to predict. However with liberalisation, the offtaker’s market share may change more quickly and unpredictably so that taking a long term analysis of demand becomes very difficult. In such a situation the take or pay contracts may transform form being long term obligations or, in some cases, hedging instruments into risk generating contracts if the incorrect commercial decision is taken. However the impact of liberalisation on long term take or pay contracts are better appreciated with regard to the gas and electricity industry in Europe and the United States.

The UK gas industry provides a good starting point. British Gas Corporation was the only buyer of gas in the UK and was in charge of transmission and distribution with its network of pipelines. In 1990s British Gas Plc was privatized and it inherited long term purchase contracts with gas producers. The joint effect of the EU directive which lifted the restriction against use of gas for power generation and opened up new markets in gas along with the release of short term gas supplies by British Gas under the gas release programme lowered spot gas prices sharply below contract price levels. The level of decrease was such that the contract prices became unsustainable.

The liberalisation of the UK electricity supply industry resulted in the unbundling of the central electricity generating board and the grant of new generation licenses to permit new entrants to compete with National Power Plc and Powergen. Liberalisation created a market trade system where electricity could be freely traded as a commodity like any other fuel source. A new system of setting prices was created where generators sold power to the public electricity supplier. The pool process were highly unstable but were hedged through contracts for differences which was also the basis for financing power projects until retail competition was brought in thereafter. The structure of the market caused a strong disincentive for entering into long term contracts for fuel supply, as a generator with a high price gas supply would be setting itself up for financial risk where the pool price becomes uncompetitive.

In case of oil it is slightly different. It was the price fluctuations of the mid 1970s that reduced the value of long-term contracts in oil project financing arrangements. The parties largely became reluctant to bind themselves for prolonged periods or to agree to fixed price. More preference is given to short term contracts with flexible pricing provisions which protect against the fluctuations in the everyday oil price.

In order to evaluate the disputes faced by lawyers for long term take or pay contracts the controversy relating to the natural gas industry need to be broadly discussed. This discussion will reveal the main problems faced by buyers and producers of a long term take or pay contract and the defences which are used by the buyers in order to excuse themselves from performance and the producers to enforce the contracts. Take or pay clause were in most instances agreed by both parties in an economic and regulatory climate that made it both realistic and effective. Pipelines and producers believed that the take or pay clause usually provided the producers with a steady income stream, and at the same time giving pipelines as assured supply of natural gas. The take or pay clause also provided pipelines with a flexibility in the volumes of gas they were required to purchase, since there was minor fluctuations in demand due to weather changes, seasonal variations or other operational reasons [9] .

However during the middle to late 1970s a serious shortage of natural gas developed in the interstate market which led to the introduction of the Natural Gas policy Act 1978 [10] (NGPA) and harsh regulation by the Federal Energy Regulatory Commission (FERC) to restructure the natural gas industry. Hence, contracts for natural gas purchase were drafted under a set of assumptions about the natural gas market and federal regulation became victim to revolutionary changes in the industry. NGPA 1978 established new and in some cases much higher wellhead price ceilings for various categories of gas: ‘old gas’, ‘new gas’ and ‘deep gas’. Following the passage of the NGPA many gas-hungry interstate pipelines having been forced to reduce their customers began bargaining with the producers for new gas supplies. Afraid that there would not be enough supply to meet demand they locked themselves into rigid long term contracts with non-market responsive pricing provisions and high take or pay requirements.

In 1978 market predictions for future gas demand was hugely miscalculated. A number of situations, which included greater energy conservation, lowering prices for alternative fuels, a nationwide economic recession, and increasing and nonflexible prices for new gas led to a huge decrease in demand for gas and a steady rise of a surplus of natural gas. The take or pay contracts (not including exculpatory clauses) obligated pipelines to take a contracted minimum volume of gas or to pay for that gas , in spite of the disappearance of traditional market demand. Furthermore these contracts bound the pipelines to contract prices which were far in excess of market clearing prices in the newly developing ‘spot’ market. Producers sought enforcement of their natural gas purchase contracts concerned with only the price and quantity clauses of their particular contracts. On the other hand pipelines were confronted with potential contractual liability on a system wide scale. Producers and pipelines renegotiated their contracts to reflect the change in the natural gas industry. Where renegotiation was refused by the producers, the pipelines sought to avoid the harsh result produced by enforcement of obsolete take or pay clauses raising the exculpatory clauses of the contracts or by other defences to contract enforcement.

Some of the pipelines successfully defended themselves against the take or pay claims. In most cases, the success was based upon favourable contract language and force majeure clauses that provided relief or atleast created a factual question which prevented summary judgement. The pipelines have also relied on many other affirmative defences to excuse their performance which however met with limited success at the trial court level. Justices Kauger and Opala in Golsen v ONG western Inc [11] made it clear that the defense to liability of commercial impracticability under title 12A, section 2-615 of the Oklahoma statutes may yet be available to pipelines. Producers often assert a cause of action for anticipatory repudiation in an effort to improve their total damages. Although anticipatory repudiation is not an affirmative defence it is routinely contested by pipelines where the anticipatory breach is based on the pipelines interpretation off the gas purchase contract. The conservation defence has now been strictly limited by the Oklahoma Supreme Court in Golsen. Additionally pipelines have asserted many other defences to liability under take or pay contracts, including penalty, public policy, liquidated damages, illegality and unconscionability.

Producers assert that take or pay clauses of a contract produce the risk of market fluctuation to the pipeline. Thus, it is argued that the force majeure clause does not excuse performance in such a situation. Where the pipeline does not rely on market fluctuations as a base for force majeure, this argument is inapplicable. In many occasion the producers like better to make this argument rather than deal with the specific contract language in issue. The excuse which is provided by the force majeure clause cannot be ignored where that clause particularly addresses the supervening event.

Force majeure clause reduces the harshness of take or pay provisions of a natural gas contract [12] . The RESTATEMENT (Second) of Contracts particularly identify that force majeure clauses are one of the common agreements by which parties are able to shift risks and limits their obligations. The Uniform Commercial Code (as discussed before) also contemplates that parties may expand the parameters of the excuse provided by title 12A, section 2-615 of the Oklahoma statutes. Force majeure clause allocates particular risks under a contract, but for that to be active the exculpatory language of the clause must clearly define the supervening event. Pipelines have generally been unsuccessful when they attempted to excuse performance relying on a ‘catch all’ provision for unspecified events. A force majeure clause must be honoured when a specific event occurs which is covered by the clause. Then the question is whether the particular terms of force majeure have been satisfied, which is a question of fact, one for the jury to decide.

In Golsen, the pipeline relied on a force majeure clause that would excuse performance in the event of a ‘failure of gas supply or market’. The district court agreed to this argument. However, the Oklahoma Supreme court reversed. The Oklahoma supreme court held that the pipelines interpretation of the ‘failure of markets’ provision ‘frustrates the basic premise of the contract’ which was to require payment for gas which is not taken by the pipeline. The court held that the force majeure clause was inconsistent with the contract’s general intent. Thus the pipeline was not excused from performance [13] . However the decision in Golsen is not a death knell to the force majeure defence in general. It was a small portion of a particular force majeure clause that was determined by the court. Other contractually agreed upon events, not addressed in Golsen may still provide the basis for defence. Justice Kruger in the concurring opinion notes stated that depending on different facts of each case, there may be occasions where the market-clause, the force majeure clause or commercial impracticability may provide the question of fact for the jury. An assessment of the facts of each case will be required to decide the availability of the force majeure clauses.

Furthermore the producers emphasize that the defence of commercial impracticability is not available to the pipelines on a number of grounds. This argument is based on the concept that market fluctuations or the intervention of governmental regulation are the types of risks which are foreseeable, and thus the risk of these events occurring must have been assumed by a party under the contract [14] . Where the risk is already assumed by a party the defence of commercial impracticability is unavailable. Additionally courts have found that an increase in the cost of performance cannot be used as an excuse of non-performance. The court redefined the availability and status of the defence of commercial impracticability in Golsen.

The courts in deciding the availability of the defence of commercial impracticability base their decision on the foreseeability of a supervening event at the time of contracting. Under common law, in order to use the defence as an excuse a supervening event must have been unforeseeable at the time of contracting. However modern rule has eased the stern restraints on parties whose contract has been invalidated by drastically changed circumstances. Section 2-615 of the Oklahoma statutes allocates the risk not assigned in the contract. The statue looks at the basic assumptions of the parties and not foreseeability in order to determine whether an excuse is available. It further identifies that the foreseeability of a risk does not essentially address its allocation. The basic assumptions of the parties and not the hindsight determination of foreseeable risks are now pertinent to the application of the defense.

Justices Kauger and Opala in Golsen recognized that the requirement of nonforeseeability has strictly limited the application of the doctrine and it “is so logically inconsistent with the defense that the application of such a standard would nullify the doctrine” [15] . Hence the foreceeability of a risk alone should not be decisive of its allocation. In Golsen if proof had been available then Justices Kauger and Opala would have been open to the concept that allocation of risk for unforeseeable events may be unforeseeable if it falls outside the parties basic assumptions. While the parties in Golsen may have allocated the risk to ONG of an increase in price, any rise beyond that contemplated by the parties after the enactment of NGPA may have cause the contract to be impracticable to perform. An inspection of the basic assumptions of the parties is required before the defence of commercial impracticability is available.

The producers also argue on another separate ground for unavailability of the defense of commercial impracticability. They argue that an increase in the cost of performance does not give an excuse to use the defense. Fixed price contracts usually provide the risk of price increases to a party. However, where the increase is outside the basic assumption of the parties, it should provide an excuse of performance [16] .

In Golsen however, justices Kauger and Opala stated that the defense of commercial impracticability may be available if there is an increase in expense. They stated that in order to show unreasonable expense a mere showing of loss under the contract is not enough. To meet the requirements the applicant must show an extreme and simply not an unreasonable expense. The extremity of the increase in cost may be shown by the effect on the financial health of the party or the necessity of bankruptcy. The existence of these elements shows that these were beyond the basic assumption of the parties, since no reasonable party will contract knowing that it may be ruined by a change in circumstances. Thus, the defence of commercial impracticability should not be made unavailable on the basis that the market fluctuations or governmental regulation has been assigned to the pipeline. The court must allow a factual development of the parties’ basic assumption to determine if performance should be excused.

The enactment of the Natural Gas Policy Act of 1978 and various FERC regulations dramatically changed the nature of the natural gas industry and the contractual obligations and duties of pipelines. Thus, making the long term natural gas purchase contracts impracticable to perform. The impracticability caused by these government regulations should excuse performance under title 12A, section 2-615 of the Oklahoma statutes. Title 12A section 2-615 provides an excuse for performance in two separate occasions: firstly where a party’s basic assumptions have been o