Background: Contracts for the sale of LNG traditionally limit the ability of the liquefied natural gas buyer to freely resell the cargoes acquired under the contract. This helps LNG sellers manage their markets and operations but also limits the ability of LNG buyers to optimize their supply arrangements over time. With Japan entering a period of excess LNG, such restrictions are receiving increasing scrutiny both from buyers and the Japanese government.
The Report: The Japan Fair Trade Commission conducted a survey and published a report finding that destination restrictions in many LNG sale and purchase agreements (especially those with FOB delivery terms) are likely to be in violation of the Antimonopoly Act. This finding itself was not unexpected, but the detail of what this nonbinding finding means for different classes of existing and future LNG contracts warrants careful attention.
Looking Ahead: For future LNG sales contracts into Japan with FOB delivery terms, destination restrictions will likely need to be avoided. For contract extensions, this may require existing contract terms to be amended. For existing contracts, care will need to be taken with exercising existing rights, and some provisions may even need to be renegotiated. The analysis will differ between sales with delivery at the supply source (FOB sales) and sales with a delivery point in Japan (Ex Ship sales), with restrictions harder to justify for FOB sales.
On June 28, 2017, the Japan Fair Trade Commission ("JFTC") published a report based on a survey conducted from July 2016 to May 2017 ("Report"), concluding that destination restrictions provided in liquefied natural gas ("LNG") sale and purchase agreements ("SPAs") in certain cases are likely to be in violation of the Japan Antimonopoly Act ("AMA"). As a result, sellers and buyers of LNG into Japan will need to modify their future contracting approaches and review their existing contracts and contract management processes.
Background and Context
After the Great East Japan Earthquake in 2011, Japan increased LNG imports mainly because all the nuclear power plants in Japan were shut down, and instead, thermal power plants started to consume larger amount of fossil fuel. However, nuclear power plants are restarting operation little by little following tightening of regulations on safety, and at the same time, renewable energy has increased its presence in Japan. As a result, we are likely entering into a period of excess LNG in Japan, which is the largest LNG importer in the world. With such excess LNG, buyers will be looking for ways to manage their supplies going forward; however, it will not be easy for buyers to resell surplus LNG to third parties due to destination restrictions contained in a large number of LNG SPAs.
In the meantime, in light of the increased significance of LNG as an energy resource, the Japanese government started to show an interest in destination restrictions in LNG SPAs. In April 2014, the Basic Energy Plan—referring to removal of destination clauses in LNG SPAs—was endorsed by the Cabinet. In addition, in May 2016, the Ministry of Economy, Trade and Industry published "Strategy for LNG Market Development" at the G7 Energy Ministerial Meeting, which expressed that Japan considers it is essential to relax and abolish destination restrictions in LNG SPAs in order to facilitate free trade of LNG and as part of the strategy to become an Asian LNG trading hub.
Other forces have also combined to put pressure on destination restrictions, including review and regulation by the European Union in the 2000s, the rise of destination-free sales out of the United States (where approved), Japan's desire to create an LNG trading hub, and the general "buyer's market" in LNG that has persisted for some time.
Against this background, the JFTC conducted the survey and published the Report in June of this year. The Report, while not legally binding, is likely to have significant impact on LNG contracting into Japan and perhaps more widely as well.
Key Points of the Report
Destination and Diversion Restrictions. The Report examined "destination restrictions," which include "destination clauses" (clauses listing acceptable ports for delivery) and "diversion clauses" (clauses preventing nomination of other ports for delivery), and assessed their likely status under the AMA, looking at the impacts of these clauses under both FOB and Ex Ship (DES) contracts.
Under FOB contracts, title to and risk of LNG are transferred from sellers to buyers at the loading terminal of the LNG shipping port, and sellers are not responsible for the transportation of the LNG thereafter. As the seller is not responsible for shipping, the JFTC did not see destination clauses as necessary and stated that they are "likely" to be in violation of the AMA. Further, the JFTC concluded that "the restrictions on diversion as well as the provision of destination clauses are not generally considered as reasonable" and are "highly likely" to be in violation of the AMA.
Under Ex Ship contracts, since the title to and risks of LNG are transferred from sellers to buyers at the unloading terminal of the destination port and sellers are responsible until the unloading of LNG at the destination port, the JFTC accepted that destination clauses are necessary and are unlikely to have AMA issues. Also, the JFTC stated that because sellers need to confirm whether they can bear responsibility for diversion, "the provision to require 'seller's consent' to diversion or the provision of the necessary and reasonable requirements to diversion does not have in itself any issues" under the AMA. However, even though having destination restrictions in an Ex Ship contract may not itself violate the AMA, the JFTC stated that if a seller does not give consent to a diversion, where a buyer's request meets any requirements of necessity and reasonableness, such refusal is "likely" to be in violation of the AMA. In addition, the JFTC cautioned that if a seller imposes competition-restraining requirements for diversion, such as the prohibition on commercial resale, it is "highly likely" to be in violation of the AMA.
Profit-Share Clauses. Profit-share clauses are those imposing an obligation on buyers to share with sellers any profits derived by reselling LNG to third parties by means of a diversion.
For FOB contracts, since title to and risk of LNG are transferred from sellers to buyers at the loading terminal of the shipping port, the JFTC saw no reasonable ground for profit sharing. Therefore, the JFTC concluded that profit-share clauses are "highly likely" to be in violation of the AMA.
In contrast, under the Ex Ship term, since the title to and risks of LNG are transferred from sellers to buyers at the delivery point of the destination port and sellers are responsible until the delivery, profit sharing as a result of resale of LNG through destination diversion can be regarded as a kind of compensation for changing contractual requirements, and it may be considered reasonable. Therefore, the JFTC concluded that "(p)roviding profit share clauses does not have in itself any issues" under the AMA. The JFTC said, however, that it is "likely" to be in violation of the AMA when profit-share clauses "contribute to unreasonable profit sharing with a seller" or "when such clauses have some effects to prevent a buyer from reselling due to a seller's request for the disclosure of the profit or cost structure."
Take or Pay Clauses. Take or Pay clauses are those imposing an obligation for buyers to pay for all the contracted volume of LNG even if buyers do not actually receive that volume. Since an LNG project needs a large amount of initial investment and loans, the JFTC concluded that providing Take or Pay clauses "does not have in itself any issues" under the AMA. The JFTC stated, however, that strict minimum purchase obligation as well as providing Take or Pay clauses are "likely" to be in violation of the AMA as Unfair Trade Practices (Abuse of Superior Bargaining Position) "when a seller's bargaining position is superior to that of a buyer and the seller unilaterally imposes Take or Pay clauses and strict minimum purchase obligation without sufficient negotiation with the buyer even after the seller has already got sufficient return for initial investment." This is a potentially significant finding that warrants further consideration.
At the end of the Report, the JFTC gave a warning to LNG sellers that: (i) at the time of concluding a new contract or renewal of existing contracts, LNG suppliers should not include provisions or adopt trade practices which anti-competitively prevent resale of LNG by buyers; and (ii) even in case of the existing contracts before expiration, anti-competitive trade practices to prevent resale of LNG by buyers are required to be reviewed and amended. Also, as a future course of action, the JFTC expressed that the "Japan Fair Trade Commission will keep monitoring the LNG market and take strict actions against any violations of the Antimonopoly Act." Precisely what steps it would take is not stated.
In addition to the uncertainty as to next steps that might be taken by the JFTC, it should also be noted that not all contracts fit neatly into the categories used in the Report's conclusions. For example, delivery terms can use variations on "FOB" or "Ex Ship," and those variations could be relevant to the AMA analysis. Also, destination, diversion, and profit-sharing terms themselves can differ significantly. For example, a restriction that can be used only when there is a genuine operational challenge for an Ex Ship seller would appear less likely to offend than an unfettered restriction, although all clauses will need to be considered. Further, when interpreting any contractual provision, governing law and context also may affect the meaning of a provision, noting that the AMA can apply irrespective of the governing law of a contract.
For these reasons, each buyer and seller of LNG into Japan will need to audit its existing contracts and contract management approaches. For example, decisions around diversion approvals may require referral to legal departments and need to be properly documented and recorded. Also, sellers and buyers should consider whether certain provisions will need to be renegotiated.
Participants in other markets should also consider these changes, both in terms of possible opportunities for broader LNG trading and also for possible knock-on effects such as responses by other regulators, particularly in Korea and China, or general changes in contracting practices.
Three Key Takeaways
- Those negotiating contracts for the sale of LNG into Japan, whether new contracts or extensions of existing contracts, must have careful regard to the findings in the Report. In particular, it would appear very difficult to include destination restrictions as they are in FOB contracts, and any restrictions in Ex Ship contracts would need to be carefully considered and drafted.
- In addition, those managing existing LNG contracts into Japan will need a strategy in response to the Report. We would recommend sellers conduct an audit of their existing contracts and implement appropriate changes to their contract management procedures.
- Those interested in the broader LNG market should take time to understand the findings of the Report and consider what other risks and opportunities they may trigger.