1. NETTING AND OFFSET PRINCIPLES IN ENERGY TRANSACTIONS CRAIG R. ENOCHS Jackson Walker L.L.P. 1401 McKinney, Suite 1900 Houston, Texas 77010 State Bar of Texas 24 th Annual Advanced Oil Gas & Energy Resources Law Course October 5-6, 2006 Houston, Texas Chapter 9

2. 2 Introduction I.Netting, Setoff, and Recoupment II.Treatment in Bankruptcy III.Treatment in Energy Commodity Contracts IV.Treatment in Joint Operating Agreement

3. 3 I. Netting, Setoff, and Recoupment A.Netting 1.Net all transactions to a single amount 2.Usually bilateral and determined by discussions between the parties in advance 3.Single agreement 4.Routine, recurring procedure

4. 4 I. Netting, Setoff, and Recoupment A.Netting 5.One payment is made 6.Benefits: Convenience Efficiency Reduces the number of invoices and payments 7.Bookouts

5. 5 I. Netting, Setoff, and Recoupment A.Netting Example: Party A and Party B are Parties to a NAESB. Under the NAESB: Party A owes $1,000,000 Party B owes $250,000 Result: Party A pays Party B $750,000

6. 6 I. Netting, Setoff, and Recoupment B.Setoff 1.Sometimes referred to as offset 2.A creditors right to reduce the amount of a debt by the amount the creditor owes the debtor 3.Any excess will still be owed to the creditor 4.Usually unilateral and communicated by notice from one party to the other 5.Usually arises when contractual relationship ends and debtor cant or wont pay

7. 7 I. Netting, Setoff, and Recoupment B.Setoff 6.Arose under common law 7.One contract or multiple contracts Setoff across affiliates may not be enforceable 8.Benefits Extinguishes obligations without further action Eliminates credit risk to the extent of the setoff Eliminates cash flow risk

8. 8 Party AParty B $50,000 $25,000 Party B:Files for bankruptcy Party A:Terminates transactions Liquidates transactions Result: With Single Agreement SetoffParty A pays $25,000 Party B pays $-0- Without SetoffParty A pays $50,000 Party B pays $25,000 in bankruptcy dollars I. Netting, Setoff, and Recoupment B. Setoff 1.Single Agreement MMBtu

9. 9 Party A Party B Power $10,000 MMBtu $50,000 Party B:Files for bankruptcy Party A:Terminates transactions Liquidates transactions $25,000 I. Netting, Setoff, and Recoupment B. Setoff 2. Cross-Product

10. 10 Party A Party B Power $10,000 MMBtu $50,000 Result: With Cross-Product SetoffParty A pays $15,000 Party B pays $-0- With Single-Agreement SetoffParty A pays $25,000 and Party B pays $10,000 in bankruptcy dollars Without SetoffParty A pays $50,000 and Party B pays $35,000 in bankruptcy dollars $25,000 I. Netting, Setoff, and Recoupment B. Setoff 2. Cross-Product

11. 11 Power MMBtu $50,000 $25,000 Party B and Party B Affiliate file for bankruptcy Party A: Terminates transactions Liquidates transactions Party A Party B Affiliate $55,000 Power $40,000 Party B and Party B Affiliate owe to Party A Party A owes to Party B and Party B Affiliate MMBtu $50,000.00 Power $40,000.00 $90,000.00 MMBtu $25,000.00 Power $55,000.00 $80,000.00 I. Netting, Setoff, and Recoupment B. Setoff 3. Triangular Cross-Affiliate/Cross-Product

12. 12 Power MMBtu $50,000 $25,000 Result: With Triangular Cross-Affiliate/ Cross-Product Setoff Party A Party B Affiliate $55,000 Power $40,000 I. Netting, Setoff, and Recoupment B. Setoff 3. Triangular Cross-Affiliate/Cross-Product Party A pays Party B and Party B Affiliate $10,000 Party B and Party B Affiliate pay Party A $-0-

13. 13 Power MMBtu $50,000 $25,000 With Cross-Product SetoffParty A pays Party B $-0- Party A pays Party B Affiliate $40,000 Party B pays Party A $30,000 in bankruptcy dollars With Single Agreement SetoffParty A pays Party B $25,000 Party A pays Party B Affiliate $40,000 Party B pays A $55,000 in bankruptcy dollars With No Setoff Party A pays Party B $50,000 Party A pays Party B Affiliate $40,000 Party B pays Party A $80,000 in bankruptcy dollars Party A Party B Affiliate $55,000 Power $40,000 I. Netting, Setoff, and Recoupment B. Setoff 3. Triangular Cross-Affiliate/Cross-Product

14. 14 Derivatives MMBtu $50,000 $25,000 Party B:Files for bankruptcy Party A: - Terminates transactions - Liquidates transactions Party A Party B Affiliate $55,000 Power $40,000 Party B and Party B Affiliate owe to Party A and Party A Affiliate Party A and Party A Affiliate owe to Party B and Party B Affiliate MMBtu $50,000.00 Power $45,000.00 $95,000.00 MMBtu $25,000.00 Derivatives $62,000.00 $87,000.00 Party A Affiliate Power $5,000 Derivatives $7,000 I. Netting, Setoff, and Recoupment B. Setoff 4. Rectangular Cross-Affiliate/Cross-Product

15. 15 Derivatives MMBtu $50,000 $25,000 Party AParty B Affiliate $55,000 Power $40,000 Party A Affiliate Power $5,000 Derivatives $7,000 I. Netting, Setoff, and Recoupment B. Setoff 4. Rectangular Cross-Affiliate/Cross-Product Result: With Rectangular Cross-Affiliate/ Cross-Product Setoff Party A and Party A Affiliate pay Party B and Party B Affiliate $8,000.00 Party B and Party B Affiliate pay Party A and Party A Affiliate $-0-

16. 16 Derivatives MMBtu $50,000 $25,000 Party AParty B Affiliate $55,000 Power $40,000 Party A Affiliate Power $5,000 Derivatives $7,000 I. Netting, Setoff, and Recoupment B. Setoff 4. Rectangular Cross-Affiliate/Cross-Product Result: With Triangular Cross- Affiliate/Cross-Product Setoff Party A and Party A Affiliate pay Party B $-0- Party B pays Party A and Party A Affiliate $25,000 in bankruptcy dollars Party A and Party A Affiliate pay Party B Affiliate $33,000 Party B Affiliate pays $-0-

17. 17 Derivatives MMBtu $50,000 $25,000 Party AParty B Affiliate $55,000 Power $40,000 Party A Affiliate Power $5,000 Derivatives $7,000 I. Netting, Setoff, and Recoupment B. Setoff 4. Rectangular Cross-Affiliate/Cross-Product Result: With Cross-Product SetoffParty A pays Party B $-0- Party A Affiliate pays Party B $5,000 Party B pays Party A $30,000 in bankruptcy dollars Party A pays Party B Affiliate $40,000 Party B Affiliate pays Party A Affiliate $7,000 in bankruptcy dollars

18. 18 Derivatives MMBtu $50,000 $25,000 Party AParty B Affiliate $55,000 Power $40,000 Party A Affiliate Power $5,000 Derivatives $7,000 I. Netting, Setoff, and Recoupment B. Setoff 4. Rectangular Cross-Affiliate/Cross-Product Result: With Single Agreement SetoffParty A pays Party B $25,000 Party B pays Party A $55,000 in bankruptcy dollars Party A pays Party B Affiliate $40,000 Party A Affiliate pays Party B $5,000 Party B Affiliate pays Party A Affiliate $7,000 in bankruptcy dollars

19. 19 Derivatives MMBtu $50,000 $25,000 Party AParty B Affiliate $55,000 Power $40,000 Party A Affiliate Power $5,000 Derivatives $7,000 I. Netting, Setoff, and Recoupment B. Setoff 4. Rectangular Cross-Affiliate/Cross-Product Result: Without SetoffParty A pays Party B $50,000 Party B pays Party A $80,000 in bankruptcy dollars Party A pays Party B Affiliate $40,000 Party A Affiliate pays Party B $5,000 Party B Affiliate pays Party A Affiliate $7,000 in bankruptcy dollars

20. 20 I. Netting, Setoff, and Recoupment B. Setoff 4. Rectangular Cross-Affiliate/Cross-Product Problems Binding all affiliates All must sign Must state joint and several liability Setting off when not all affiliates are bankrupt Allocating net proceeds across the bankrupt affiliates Open issue with no case law Dynegy v. Enron – oral arguments 10/31/06

21. 21 I. Netting, Setoff, and Recoupment C.Recoupment 1.A right of a defendant to reduce a plaintiffs damages because of a plaintiffs breach of contract or duty in the same transaction 2.Defensive right Limited to same transaction as plaintiffs claim Limited to amount of plaintiffs claim

22. 22 I. Netting, Setoff, and Recoupment C.Recoupment 3.Recoupment is available in contract or at common law 4.Bankruptcy Recoupment is a defense, not a claim, so it does not constitute a claim or preference Recoupment permits a creditor to reduce prepetition debts by post petition amounts due to the debtor

23. 23 II. Treatment in Bankruptcy A.The Automatic Stay 1.Arises when a bankruptcy petition is filed 2.Automatic stay prohibits actions including : Filing or continuing suit on a pre-petition action Enforcing a pre-petition judgment Acting to obtain possession or exercise control over property of the estate The setoff of pre-petition debts Debtors payment of pre-petition obligations The termination of contracts with the debtor 3.The automatic stay protects debtors from creditors and creditors from each other

24. 24 II. Treatment in Bankruptcy B.Safe Harbor Rights 1.Forward contracts, swap agreements and financial participants receive an exemption to the automatic stay Exemption is referred to as safe harbor rights Must be forward contract merchants, swap participants or financial participants Forward contracts are contracts for the purchase or sale of a commodity more than two days after the contract is entered into, including options, security agreements related to such transactions, and master agreements. (11 USC §101(25)) Forward contract merchants are entities whose business involves entering into forward contracts (11 USC §101(26))

25. 25 II. Treatment in Bankruptcy B.Safe Harbor Rights 1.Forward contracts and swap agreements receive an exemption to the automatic stay Swap agreements are essentially financial derivative transactions, including options or master agreements for derivatives, similar agreements, and security agreements for such transactions. (11 USC §101(53B)) A swap participant is an entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor. (11 USC 101§(53C)) Financial participants are entities with forward contracts, swap agreements or master netting agreements for a gross dollar value of $1 billion or more in notional or actual principal outstanding on any day in the previous 15 months or gross mark to market positions of $100 million or more in one or more such agreement or transaction on any day in the previous 15 months. (11 USC §101(22A)) The safe harbor exemption allows the enforcement of contractual rights to terminate, liquidate, and/or setoff obligations This allows the creditor to avoid market risk on these obligations Creates a right almost equivalent to a secured claim to the extent of the setoff

26. 26 II. Treatment in Bankruptcy B.Safe Harbor Rights 2.Safe harbor rights exist to reduce market disruption when a participant goes bankrupt 3.Safe harbor rights must be created in a contract to be enforced 4.Safe harbor rights protect setoff timing

27. 27 II. Treatment in Bankruptcy C.Setoff in the Bankruptcy Code - §553(a) 1.Equitable right in the discretion of the Court 2.In order to setoff: a.Obligations setoff must have arisen prior to the bankruptcy proceeding b.Obligations setoff must be enforceable c.Obligations must be owed in the same capacity 3.Does not create a right of setoff but bars interference with these rights

28. 28 II. Treatment in Bankruptcy D.Setoff of Collateral 1.Bankruptcy Code §362(b) exempts from the automatic stay: a.The setoff of settlement payments arising out of forward contracts against collateral b.The setoff of mutual debts under a swap agreement against collateral

29. 29 III.Treatment in Energy Commodity Contracts A.NAESB 1.Natural Gas 2.Netting Parties can elect netting of monthly obligations 3.Setoff Following early termination Can elect whether setoff will apply to all agreements or only the NAESB

30. 30 III.Treatment in Energy Commodity Contracts B.ISDA 1.Derivatives 2.Netting Can elect netting to apply 3.Setoff 1992 version does not contain setoff Parties usually add in the schedule 2002 version includes a setoff provision applying to all amounts owed between the parties

31. 31 IV. Treatment in Joint Operating Agreement A.1977 and 1982 Model Form Operating Agreements [U]pon default by any Non-Operator in the payment of its share of expense, Operator shall have the right, without prejudice to other rights or remedies, to collect from the purchaser the proceeds from the sale of such Non-Operators share of oil and or gas until the amount owed by such Non-Operator, plus interest has been paid. This is the exercise of a lien and security interest rather than a netting or setoff.

32. 32 IV. Treatment in Joint Operating Agreement A.1989 Model Form Operating Agreement [U]pon default by any Non-Operator in the payment of its share of expenses, interests or fees, or upon the improper use of funds by the Operator, the other parties shall have the right, without prejudice to other rights or remedies, to collect from the purchaser the proceeds from the sale of such defaulting partys share of Oil and Gas until the amount owed by such party, plus interest as provided in Exhibit C, has been received, and shall have the right to offset the amount owed against the proceeds from the sale of such defaulting partys share of Oil and Gas. This version provides and explicit, albeit limited, right of setoff.

33. 33 IV. Treatment in Joint Operating Agreement B.Setoff Not referred to specifically in 1977 or 1982 Model Form Operating Agreement 1989 Model Form Operating Agreement Article VII contains a setoff provision If a party defaults in paying expenses, or the operator improperly uses funds, the other parties may setoff the amount owed against the proceeds from the sale of the defaulting partys oil and gas

34. 34 Conclusion Netting, recoupment, and setoff are valuable, each to achieve different goals Recoupment and setoff are especially valuable in bankruptcy Netting, recoupment, and setoff may exist as procedural or common law rights, but it is advisable to include them in your contracts and to tailor the provisions to suit your needs