The U.S. Court of Appeals for the Second Circuit recently issued an opinion that enforces an energy trading company’s contractual rights to an early termination payment under a long-dated contract. Previously, the termination payment had been disallowed by a lower court on the basis that the twenty-year period of the agreement prevented any reasonable certainty in the calculation of damages based on modeled forward prices. In Tractebel Energy Marketing, Inc. v. AEP Power Marketing, Inc., the Second Circuit vacated that portion of the lower court ruling and remanded the case to the lower court for reconsideration of damages under the proper standard. The circuit court’s ruling restores a greater measure of certainty to the complex area of valuation upon termination of long-term contracts. It now is more likely that a non-defaulting party can establish and recover early termination damages based on modeling of forward market conditions. For a copy of the decision, click here.

On November 15, 2000, Tractebel Energy Marketing, Inc. ("Tractebel") and AEP Power Marketing, Inc. ("AEP") entered into a Power Purchase and Sale Agreement (the "Agreement"). The Agreement had a term of twenty years and was essentially a requirements contract, under which AEP would supply large amounts of electric power and related products to Tractebel from a cogeneration plant (the “Plant”) to be constructed.

Beginning in 2001, certain energy markets declined significantly, leading Tractebel to realize that its profitability estimates of the Agreement had been overly optimistic. By September 2002, Tractebel had changed its projections from $80 million in-the-money to $360 million out-of-the-money.

Tractebel eventually terminated the Agreement and commenced an action in the U.S. District Court for the Southern District of New York. Tractebel asserted that AEP had breached its implied covenant of good faith and certain express provisions of the Agreement. AEP filed counterclaims, asserting that Tractebel breached the Agreement by failing to increase the amount of a supporting guaranty and to make certain payments due under the Agreement.

The district court rejected Tractebel’s claims, finding that AEP had not breached its good faith covenants and had breached the Agreement only in immaterial respects. With regard to AEP’s counterclaims, the district court held that Tractebel had breached the Agreement by failing to increase its credit guaranty and to make the required payments.

In determining the amount of damages due to AEP, the district court allowed damages in the amount of $123 million relating to past due (pre-termination) amounts that Tractebel had failed to pay. The district court, however, refused to allow AEP to recover damages based on the termination payment clause contained in the Agreement – damages which according to AEP’s projections amounted to approximately $500 million. The district court reasoned that the termination payment essentially was a means of recovering lost profits from the Agreement, and that the law traditionally allows recovery of lost profits only if the party seeking recovery can establish the existence and amount of the damages with reasonable certainty. It found that, in part, due to the long term of the Agreement and the number of market assumptions built into AEP’s model of forward price projections, AEP was unable to establish its lost profits with reasonable certainty. Both parties appealed the district court’s ruling to the Second Circuit. Tractebel sought to have the circuit court overturn the findings that AEP did not breach; AEP sought to have its damages associated with the termination payment clause restored.

The Second Circuit affirmed the district court’s holding with respect to the absence of breach by AEP and with respect to Tractebel’s liability. It disagreed with the district court with regard to the $123 million award for pre-termination amounts due, vacating that award of damages.

As to the larger issue, the circuit court agreed that termination payments are essentially a claim for lost profits. The Second Circuit disagreed with the district court, however, regarding the consequences of that classification. The circuit court distinguished between (a) general damages – the damages suffered as a direct result of the breach, and (b) consequential damages – those suffered when a breach renders a party unable to perform its obligations, which in turn affect its collateral business arrangements. The circuit court noted that lost profits must be established with reasonable certainty in the case of consequential damages, but that AEP’s lost profits were general damages. The Second Circuit concluded that when the lost profits being sought arise as a direct result of the breach, such a high certainty regarding the amount is not required. The non-breaching party must prove the existence of damage with reasonable certainty, but as to the projections of the damages, less certainty is acceptable. Accordingly, the circuit court vacated the lower ruling and remanded the matter to the district court for reconsideration of the damages under the proper standard.

Having concluded that AEP need not establish its lost profits with certainty, the Second Circuit proceeded to explain the supporting policies for such a rule. Every product and service, it noted, is affected by long-term fluctuations in supply and demand, operating costs, and other changes. Although such variables exist in every long-term contract, the court stated, the law cannot allow “all such contracts [to] be breached with impunity because of the difficulty of accurately calculating damages.”

Any party that has seen a long-term contract (or a contract in an illiquid market) terminated knows the inherent difficulties and potential variable assumptions necessary to determine the forward value of such a contract. Certainly, the district court was correct that some degree of speculation as to what may happen in the future exists in any such valuation process. Nevertheless, the Second Circuit’s ruling is significant in that it restores a greater degree of needed certainty to an already complex area. Had the district court ruling been allowed to stand, modeling and valuation of long-dated contracts would have been certain enough for the purposes of companies’ business decisions and for banks to lend capital, but not sufficiently certain for a non-defaulting party to recover forward damages from a defaulting counterparty. Energy traders would have needed to reexamine their contracts and find new ways to allocate default and forward price risks. Older contractual provisions would have been inadequate, creating significant uncertainty under their existing agreements. Instead, the recent Second Circuit decision reestablishes a greater degree of predictability, and preserves the benefit of the bargain in energy traders’ contracts.