Take-or-pay provisions are now fairly common in long-term offtake and supply agreements in the energy sector, a notable example being gas supply agreements.1
In essence, take-or-pay provisions provide that a buyer must pay for specified quantities of energy (gas, for example) from a seller, even if the buyer is unwilling or unable to take such quantities.2 At the most basic level, take-or-pay clauses require the buyer either to purchase and take delivery of certain quantities of gas, or to pay for the gas regardless of whether it takes delivery.3
The aim of these provisions is to ensure that the seller will receive a guaranteed stream of revenue under the agreement, irrespective of the quantities actually taken by the buyer. They often operate where the supplier has had to undertake substantial debt and capital commitments in order for the project to get off the ground in the first place. 4 (At the same time of course, Buyers have themselves often had to undertake commitments as well; consider regas facilities in an LNG project.)
Although take-or-pay clauses are widely used, the rules applicable to such clauses, under most national laws, are not fully settled. The concern frequently expressed is whether these provisions constitute a form of penalty which a court or arbitral tribunal should not enforce.
One need only take the (rare) situation where a buyer cannot take a quantity of gas but must still pay for it, and couple that with the (rarer) case where the seller is thereby able to sell that gas to someone else.5 Under a traditional take or pay scenario, the buyer will not be able to claim a credit for the other sale, and so the seller is in effect paid twice. The question then arises, is the fact that the buyer is being asked to pay an amount over and beyond the seller’s actual loss a matter for concern? And if so, should the provision be held unenforceable as a penalty clause?
One argument against this is that, in the context of gas contracts agreed between large and experienced companies on the basis of legal advice, take-or-pay provisions are not unreasonable and parties should be held to their commercial bargain. This argument is strengthened by the frequent mitigation of the potentially harsh effects of take-or-pay clauses by the use of one or more of the mechanisms described in II.B. An allied argument is based on the fact that one of these mechanisms which is often included involves "make-up", where the buyer can reclaim the gas for which it paid at a later date. Where the buyer does eventually take the gas, the situation may (depending on the wording of the contract) be characterized as delayed performance. The initial payment should not therefore be viewed as a penalty for a breach of contract (a point to which I return in Part II.A below). Other technical arguments of a more legal nature seek to characterize the underlying obligation as a simple debt (see III.A below) or an obligation subject to an order for specific performance. These arguments explain why courts and tribunals called upon to review take-or-pay clauses have generally tended to uphold them.
This article is intended to shed light on some of the uncertainties surrounding the legal treatment of take-or-pay clauses, by presenting an overview of the practice of take-or-pay conditions in gas supply contracts (II.) and reviewing how these clauses are interpreted and enforced in common law and civil law systems, as well as under European Union ("EU") and certain Arabic laws (III.).
- Take-or-Pay Conditions in Practice
- Economic Rationale behind Take-or-Pay Clauses
- Take-or-Pay Conditions as a Risk Allocation Mechanism in Long-term Contracts
A defining characteristic of projects in the energy sector is that they frequently require significant upfront capital investments on the part of producers for the exploration, design and construction of the facilities.
This opens the door to what some economists refer to as the "hold up problem": certain buyers may have an incentive to take advantage of the investments made by the seller (which strengthen the buyer’s bargaining position, since these investments have little value for other uses) to thereby increase their share of the profits generated by the relationship.6 To help deal with this problem, buyers and sellers enter into long-term contracts, which are intended to guarantee a stream of revenue to the seller on pre-determined terms.
In simple terms, the quid pro quo involved in these arrangements involves an assumption of different risks. In order to be able to market the gas (in Europe at least) the buyer seeks accommodation and protection through price flexibility, ensuring that the price it pays still allows it to market the gas in its chosen market. This can be provided by price indexation, and – where circumstances warrant – a reopening of the price formula itself. Hence, the seller assumes a degree of price risk over the life of the contract.
Sellers, on the other hand, having committed substantial sums into the project – often backed by banks whose sole recourse is the project itself – require assurances as to ongoing income. Hence, they ask buyers to take supply risk through the imposition of take or pay. The aim is thus to ensure that the seller will receive at least a minimum level revenue stream defined at the outset of the contract.
- Take-or-Pay as Collateral in Project Financing
As can be readily seen, in addition to being risk allocation mechanisms, take-or-pay conditions may also operate as indirect guarantees in the context of project finance, where the only recourse open to the banks may be the project itself. In such cases, a constant revenue stream is generally a condition sine qua non of the project’s feasibility, and hence financing.
This unconditional payment obligation means that take-or-pay contracts may be characterized as a form of guarantee, reportable as such on financial reports.7 Similarly, buyers may have to seek the approval of their own lenders before entering into agreements subject to a take-or-pay condition.8
- How Take-Or-Pay Provisions Operate
There are various types of take-or-pay clauses, although the key mechanism of these provisions remains essentially the same: the buyer is obliged to either take (and pay for) or pay for (even if not taking) a minimum quantity of gas specified in the contract.9
Given, however, commercial pressures and the ever-present concern that these provisions may be challenged as (unenforceable) penalties, the industry has usually softened the potentially harsh effects of take-or-pay.
The following elements are examples of the main variables that can alleviate the mechanics of each take-or-pay obligation:10
- Take-or-Pay percentage: a take-or-pay commitment is generally based on a percentage of the contract quantity, typically expressed as x% of the deliverable quantity under the contract in the normal course of events.11 A higher percentage obviously means higher guaranteed cash-flow for the seller. The take-or-pay percentage in gas supply agreements is in our experience generally set at between 75% and 95% of the contract quantity.12
- Periodicity: the frequency of application defines the periodicity of the imposition of the take-or-pay obligation on the purchaser (monthly, quarterly or yearly). Longer periods provide additional flexibility to the purchaser, at the expense of reduced protection for the seller.
- Make-up Quantities: very often, the buyer has the right to reclaim the gas for which it has paid at a later date, usually subject to a final deadline after which the right is lost (and the right is generally exercisable only once its ongoing obligations have been satisfied in any given year).13
- Adjustments: adjustments involve circumstances set out in the contract that, if they occur, may result in a reduction of the contract quantity. Such adjustments include, for instance, force majeure events, shortfall gas (i.e., quantities that the seller was unable to deliver), or maintenance (i.e., quantities which were not delivered because the facilities were undergoing maintenance).
While beyond the scope of this article, another "softening" mechanism could be where hardship provisions operate either by way of contract or applicable law, a question which opens up a whole host of other issues.14
- Validity and Enforcement of Take-or-Pay Provisions
A review of the treatment of take-or-pay conditions in various countries shows that their validity and enforcement remains subjects of discussion; in common law (A.) and civil law (B.) systems, as well as under EU law (C.) and "Arabic" law (D.) systems.
- Take-or-pay conditions in Common Law Systems
Take-or-pay clauses were first included in US gas contracts in the 1960s, playing a key role in the balance of commercial relationships between producers and pipeline companies. Take-or-pay clauses generated significant litigation after the recession of 1981-1982, as buyers were subject to high take-or-pay obligations for quantities of gas that exceeded market demand, coupled with the fact of market prices having dropped well below the contract price.15
The validity of take-or-pay conditions is generally not challenged in the US, as courts have frequently upheld this type of provision in principle.16 This said, the results of the application of these provisions (i.e., the possibility of the seller recovering the full amount under the take-or-pay clause) have in some cases been subject to question.
This uncertainty stems in large part from the Uniform Commercial Code ("UCC"), in force in most US States and which is generally recognised as applying to gas sale contracts. Section 2-708 of the UCC provides that in the event that the buyer refuses to take delivery of the goods, the seller is entitled to "the difference between the market price at the time and place of tender and the unpaid contract price together with any incidental damages".17
- In certain cases, US courts have held that Section 2-708 applied to the calculation of damages arising out of the breach of a take-or-pay obligation (i.e. where the buyer has not taken or paid for the gas), thus entitling the seller only to the difference between market price and contract price.18
- However, other courts have found that take-or-pay clauses are derogations from the general rule of Section 2-708, and the payment obligation is enforceable in full.19
Uncertainties also exist in English law, regarding whether take-or-pay obligations are subject to the rule against penalties. The rule provides that English courts will not allow the enforcement of a provision which imposes a penalty on a party which has breached a contract. Penalties, which are unenforceable, must of course be distinguished from liquidated damages, which are per se enforceable. The main difference between penalties and liquidated damages is that liquidated damages are intended to be a genuine pre-estimate of the damage that a breach would cause, whereas penalties primarily operate to deter a breach (in terrorem). A provision interpreted as a penalty will be disregarded, and the amount stated therein will not be recoverable as damages.20 Any loss suffered by the aggrieved party would then be subject to the normal rules governing damages (e.g., proof, mitigation, etc.).
This issue was discussed in M&J Polymers v. Imerys Minerals Ltd,21 which concerned an agreement for the supply of chemicals subject to a take-or-pay obligation. Burton J in the English High Court appeared to consider the true nature of the claim as an action for damages, and not – as was argued – an action for a simple debt (where the normal damages rules would not apply). Accordingly, the Court found that "as a matter of principle, the rule against penalties may apply" to take-or-pay clauses. The Court then proceeded to examine whether the take-or-pay obligation infringed the rules on contractual penalties.
In conducting this test, the Court considered the following four factors:
- Whether the take-or-pay clause was oppressive;
- Whether the take-or-pay clause was commercially justifiable;
- Whether the primary purpose of the take-or-pay clause was to deter breach of contract; and
- Whether the parties enjoyed equal bargaining power.
Based on these four criteria, the Court held that the take-or-pay clause included in the agreement between M&J Polymers and Imerys was reasonable and did not amount to a penalty.22 (One might note that the fourth condition set out above is likely to apply in the majority of upstream contracts.)
The same reasoning was recently applied by the High Court in the case of E-Nik Ltd v. Department for Communities and Local Government.23 Burton J, the same judge who decided M&J Polymers, again held that a take-or-pay clause may, as a matter of principle, be considered as a penalty clause. He noted, however, that the clause in question was "commercially justifiable […] negotiated and freely entered into by parties of comparable bargaining power" and thus enforceable.
As evidenced by the M&J Polymers and E-Nik cases, English law does not explicitly prohibit take-or-pay provisions. However, these clauses may, under certain particular circumstances, fall foul of the rules governing contractual penalties. Contract drafters should thus be aware that take-or-pay conditions present certain risks under English law and one should consider carefully the four points set out above.
The rule against penalties was also recently considered in Australia, in the decision of the Australian High Court in Andrews v. Australia and New Zealand Banking Group Ltd ("Andrews").24 This decision concerned a class action brought against a bank, based on a claim that certain clauses included in agreements entered into by the bank (such as clauses imposing late payment fees), were unenforceable, as they constituted penalties.
By way of background, it will be recalled that one rationale for the enforceability of take-or-pay clauses is that there is in fact no breach of contract involved in a failure to take quantities, as the take-or-pay clause provides for payment and/or delayed performance (through make-up gas). In this way, there is no cause for discussing issues relating to damages since there is no breach.
As the Andrews decision now demonstrates, this may not necessarily be the end of the matter, in Australia at least.
The penalties doctrine prevents the enforcement of certain provisions calling for the payment of money if these provisions are dependent upon a breach of a contract.25 In this regard, take-or-pay clauses were traditionally not considered as penalties in Australia, since they are not triggered by a breach of contract.26
In Andrews, the High Court broadened the scope of the penalties doctrine and held that penalties could be found to exist, even if they were not triggered by a contractual breach. The Court noted, in general terms, that a contract provision amounts to a penalty if "it is collateral (or accessory) to a primary stipulation in favour of a second party and this collateral stipulation, upon the failure of the primary stipulation, imposes upon the first party an additional detriment, the penalty, to the benefit of the second party."27
This decision suggests that, like the English courts, the Australian courts will be prepared to look through the characterization of take-or-pay clauses by parties relying on them and recognize that such provisions could potentially fall foul of the rule against penalties. Although the legal and commercial justifications for take-or-pay in energy contracts means that this is likely to be the case only in more extreme circumstances, the Andrews decision should prompt caution on the part of drafters of contracts enforceable under Australian law.
There are of course a number of other defences raised from time to time, often invoking specific statutory regimes applicable in domestic regimes or more general appeals to public policy (described somewhat uncharitably by some writers as the defence "never argued at all but when other points fail"28).
In the same vein, attempts to invoke force majeure arguments have been singularly unsuccessful (a matter beyond the scope of this article).
- Take-or-Pay Conditions in Civil Law Systems
In France, although regulations in the energy sector seem to accept the principle of take-or-pay conditions in energy contracts,29 the French Competition Council ("Conseil de la concurrence") indicated that such provisions could raise competitive concerns in the context of the liberalization of the gas market.30
In addition, and reminiscent of our discussion above, take-or-pay conditions are exposed to the risk of being construed as contractual penalties ("clauses pénale") in the sense of Article 1152 of the French Civil Code.31 Where a clause is deemed to be penal, a court may review the amount of the penalty and is entitled to reduce or increase it if it is "excessive or derisory".32
To our knowledge, only one decision, issued by the Court of Appeal ("Cour d’appel") of Angers in 2005, has addressed the validity of take-or-pay clauses under French law.33 In this decision, the Court upheld the annual take-or-pay obligation accepted by one of the parties, and found that this provision was justified in the general context of the agreement. The Court noted, in particular, that the take-or-pay undertaking (i) was made in consideration of the seller’s obligation to supply natural gas, and (ii) constituted a "mode of performance of the [buyer’s] obligation to take".34 The Court rejected the argument that this take-or-pay clause could be construed as a penalty under French law. For these reasons, the Court awarded damages to the seller in the amount specified in the take-or-pay clause, as a result of the buyer’s failure to take the contract quantity.
Whilst, to our knowledge, the German courts have not yet taken a position on the precise legal rules governing take-or-pay, certain decisions rendered in the context of antitrust cases have touched upon the subject and appear to indicate that take-or-pay clauses are enforceable under German law.35
By contrast, take-or-pay clauses raise specific concerns under Russian law:
- First, under Article 16 of the Gas Supply Rules, any provisions calling for liability for failure to take gas for contracts in which the annual volume is less than 10,000 cubic meters, are prohibited.36
- Second, take-or-pay clauses may themselves be considered unenforceable under Russian law. Gas supply contracts are considered as sale and purchase contracts in the sense of the Russian Civil Code. As such, gas supply contracts are subject to the general rules of the Russian Civil Code regarding sales contracts, such as the rule requiring the quantity of the goods to be supplied being clearly specified in the contract. Take-or-pay clauses may well violate certain of these general principles of Russian law.37
- Third, take-or-pay clauses are subject to the rule in Article 333 of the Russian Civil Code, which enables courts to reduce the amount of contract penalties in the event that they are deemed to be “unreasonably high”.38 This provision was recently applied in a case decided by the Supreme Commercial Court of the Russian Federation, in which a gas supplier claimed approximately 4 million rubles, as a result of the buyer’s failure to take approximately 11% of the contract quantity under a take-or-pay obligation.39 Considering the limited extent of the breach, the court found the penalty to be unreasonably excessive compared to the actual losses incurred by the buyer and reduced the penalty awarded to the supplier to 1 million rubles.40
Turning to Switzerland, it was stated in a recent article that: "[t]he nature of ToP [take-or-pay] clauses under Swiss contract law has not yet been analyzed in Swiss case law or legal literature."41 The author of the article goes on to argue that take-or-pay clauses are nevertheless legitimate and enforceable terms providing for alternative modes of performance within the meaning of the Swiss Civil Code (and, one could posit, the codes of many other countries; see below).
The argument runs as follows. Given that under a take-or-pay clause, the buyer must either (i) take, and pay for, the agreed quantity or (ii) pay the price for this quantity without (yet) taking delivery of it, the buyer is free to choose one of these two options notwithstanding the seller’s preference. Upon performing either of these alternatives, the buyer is considered as having fulfilled its obligations under the take-or-pay agreement.
The author thus states that, irrespective of whether gas is later reclaimed, the buyer’s payment obligation "cannot be characterized as a penalty or liquidated damages" but is "an independent (alternative) obligation".42
One can see the same type of argument being made under French law as well.43
One issue that could arise, even applying this theory, is whether one can establish causa or a "lawful cause" underlying the relevant obligation.44
Under civil law notions, a buyer’s duty to pay should have a cause at the time of the contract in order for that duty to be valid and enforceable. In synallagmatic (commercial) contracts, the "cause" of the debtor’s obligation can be found in the creditor’s corresponding undertaking.45 Where there is no such provision, i.e. when there appears no counter-part granted by the creditor for the performance of the debtor’s duty to pay, one could argue that the debtor’s duty to pay has no cause and should thus be deemed null and void.
So what is the cause of the debtor’s duty to pay without taking? The answer to that question will obviously vary, although if, for instance, the creditor has provided for a "make-up" right, or entered into an exclusivity agreement (meaning it can sell to no one else)46, or if it has a duty to "supply or pay", it seems more likely that courts would consider that the cause requirement is met. The position may be more problematic, however, were there to be no corresponding rights of the nature described.47
- Take-or-pay Conditions under EU Law
Take-or-pay conditions fall within the ambit of EU regulation of the gas sector, which currently takes the form of the Third Gas Directive and the application of general EU competition law to the gas industry.
The EU adopted Directive No. 2009/73/EC (the "Third Gas Directive") in 2009,48 as a replacement for Directive No. 2003/55/ EC (the "Second Gas Directive") 49 in 2003 itself preceded by Directive No. 98/30/EC (the "First Gas Directive") in 1998.50 These three directives are intended to set out the basic rules governing the gas market within the EU, by establishing common rules for the distribution, transmission, supply and storage of natural gas.
One of the key principles of the Third Gas Directive is third party access to gas transport systems. This principle, set out under Article 32 of the Third Gas Directive, provides, in essence, that the owner of the grid must allow any supplier non-discriminatory access to its gas transmission and distribution system.
The Second Gas Directive does not directly address take-or-pay conditions. However, take-or-pay clauses are listed as one of the possible justifications for derogation from third party access. In this context, Article 48(1) of the Third Gas Directive provides that a party to a gas undertaking may request a derogation from third party access under Article 32 of the Third Gas Directive, in case it is subject to serious economic and financial difficulties as a result of its take-or-pay obligations. All of this suggests that take-or-pay obligations are prima facie valid, so far as EU legislators are concerned.
Another angle from which take-or-pay conditions may be tackled is EU competition law, notably Articles 81 and 82 of the Treaty Establishing the European Community ("EC"). Article 81 EC prohibits agreements or other concerted practices which restrict or distort competition within the Common Market. Article 82 EC prohibits abuse by undertakings of a dominant position within the Common Market. Both Articles 81 and 82 EC are directly effective provisions of EU law: national courts are thus entitled to annul contracts that breach Article 81 or 82 EC.
Take-or-pay conditions, as part of long-term gas supply contracts, may fall within the ambit of the European Commission policies regarding market foreclosure and/or restriction of competition in the Common Market. The main rule applied by the commission for gas supply contracts was defined in the 2007 Distrigas decision:51 long-term gas supply contracts are not per se prohibited, but their impact must be appreciated on an individual basis, in order to determine whether they restrict competition to an unacceptable extent. In assessing the effects of the agreement on competition, the European Commission focuses on various objective criteria (market position of the supplier, availability of the buyer for other suppliers, duration of the long-term supply contract, overall market share and benefits arising from the new contract).
- Take or Pay in Arab Speaking Countries
States such as Algeria, Egypt, Libya, and Qatar have already entered into take-or-pay agreements. Similarly, Lebanon and Syria have signed a bilateral treaty for the transportation and sale of gas whereby both states are under an obligation to enter into a gas supply contract containing a take-or-pay clause:
"Within fifteen days of the date of signature of this treaty, the parties shall sign a treaty for the sale and purchase of gas which shall include the following main provisions: […] the principle of take-or-pay […]."52
In addition, under the Algerian Hydrocarbon Law, it appears (on the wording of the Law at least) that gas supply contracts must contain a take-or-pay provision (or the wording of the Law at least):
"The company or companies in charge of gas supply activity must […] enter into a gas supply contract with each contractor chosen by the national agency for the valorization of hydrocarbon resources (ALNAFT). […] The Contract […] shall contain a "take or pay" clause […]."53
Despite the common use of take-or-pay clauses in Arab countries, their laws do not generally provide specific rules. There appears to be a general assumption that such clauses are valid.
As for their theoretical basis, and given these countries’ civil law roots, one possible approach to the issue is again to assimilate these clauses to those providing for an "alternative obligation."
The Egyptian Civil Code defines alternative obligations as follows:
"An obligation is alternative when its object includes numerous [modes of performance] and the debtor is entirely freed by the performance of one of them. The option, in the absence of any special provision in the law or of an agreement by the parties to the contrary, belongs to the debtor."54
Many other codes contain similar provisions.55
Whilst take-or-pay clauses have generally been accepted as enforceable in most jurisdictions, some recent decisions of common law courts do open the way for their validity to be questioned. In particular, English and Australian courts now appear willing to look through the form of contractual obligations and engage in substantive analysis of whether clauses should be unenforceable as penalties.
In practice, this means that the mechanisms which mitigate the effects of take-or pay clauses may become more important than has previously been assumed. Negotiators and drafters should carefully consider the level of the take-or pay percentage and the formulation of make-up provisions. Is the seller pressuring the buyer to accept "off-market" terms? Does the buyer have inferior bargaining power? Is the clause as a whole commercially justifiable? Is the provision or any element of it (such as the pricing formula for make-up quantities) punitive?56
Sellers under gas supply agreements should not, however, despair. Courts and arbitral tribunals are likely to recognize the strong commercial and legal justifications for take-or-pay clauses in energy contracts. We may still be some time away from seeing take-or-pay clauses held invalid, and this is only likely to happen in the more extreme cases if at all.