The recent rebound in the international energy industry is being driven, at least in part, by a large and growing appetite for U.S. hydrocarbon commodity products from buyers in China and other new and emerging markets. U.S. energy companies, eager to court such new opportunities, are actively contracting with a wide variety of new and emerging market buyers for the sale and export of increasing quantities of hydrocarbons, such as liquefied natural gas, propane, ethane and the like.
In the midst of these positive developments, the conduct of a particular buyer in a recently reported case out of a State Court in the energy capital of the U.S. -- Houston, Texas -- may cause U.S. energy companies to more carefully consider the nature, size and timing of payment security they are asking for as they race to sell and export hydrocarbon commodities to new and emerging market buyers.
In Mabanaft Pte. Ltd. vs. Oriental Energy Co., Ltd.1 , the buyer, Oriental Energy China (“OEC”), reneged on its payment security obligations to the seller, Mabanaft Pte. Ltd. (“Mabanaft”), under a six-year propane supply contract, before the first cargo was even delivered.
In that case, OEC claimed, among other things, that its failure to provide the required payment security was legally excused because subsequent changes in foreign exchange policies and banking restrictions in China allegedly made the procurement of such payment security impossible or impracticable. Mabanaft, the seller, responded by suspending its performance of the contract and suing OEC for breach, seeking damages for the full term of the contract. Mabanaft alleged that OEC was simply seeking to use an allegation of change in law as a pretext to avoid its contractual obligations because propane prices had shifted against the buyer since the signing of the contract. OEC then countersued Mabanaft for breach of contract arising out of Mabanaft’s refusal to perform the contract without the required payment security being in place.
The Court ultimately sided with Mabanaft and awarded damages against OEC in the amount of US$523,842,849.19 plus post-judgment interest, but the underlying facts and arguments in that case help to illustrate some of the typical risks that many U.S. commodities sellers will face. The case also provides an opportunity to more closely consider some key issues surrounding contractual payment security provisions and mechanics.
This article provides an overview of the contractual payment security structure that was present in the Mabanaft case, together with some observations on the adequacy of the contractual payment security arrangements in that particular case. We then offer three takeaways (the three “Rs”) for U.S. companies in structuring the appropriate payment security for long-term supply arrangements with emerging market buyers.
Let the Seller Beware
The full propane sale and purchase contract in the Mabanaft case was not made public (it was filed with the Court under seal), but the parties’ respective court pleadings disclosed the following relevant facts:
- The parties entered into a propane supply contract in October 2013, with delivery obligations to begin a few years later in January 2017. Commencing in January 2017, OEC was obligated to take a minimum monthly quantity of propane, on FOB Houston delivery terms (i.e., OEC was required to arrange for shipping from the place of delivery on the Houston Ship Channel) for a period of six years. Deliveries were to occur twice per month.
- Not later than 90 days before the first delivery month, OEC was required to provide an irrevocable standby letter of credit (“SBLC”) in favor of Mabanaft in the fixed amount of $5.5MM; and by not later than 5 business days prior to the nominated loading window for each cargo of propane, OEC was required to provide an irrevocable documentary letter of credit (“DLC”) in favor of Mabanaft covering the full contract price for the relevant cargo.
- The contract provided for liquidated damages if OEC breached its obligation to lift the minimum monthly quantities of propane. At the time of OEC’s failure to perform, the value of each cargo was approximately $26MM, an amount that, for even a single cargo, was significantly higher than the face amount of the SBLC. In addition, the market price of propane had increased significantly during the time period between contract signing and the date for first deliveries under the contract.
- When time came for OEC to provide the SBLC, OEC claimed that post-agreement changes in Chinese laws and regulations made its performance (including provision of the SBLC) “illegal… and/or commercially impracticable or impossible.” When OEC failed to deliver the SBLC by the required deadline and thereafter failed to respond to Mabanaft’s demand under the applicable uniform commercial code provisions for adequate assurances from OEC that it would perform the contract Mabanaft formally suspended its obligation to accept cargo nominations from OEC and sued OEC for breach of contract. In addition to its claimed defenses of illegality, impracticability and impossibility, OEC also challenged the enforceability of the contractual liquidated damages provision, and it countersued Mabanaft for breach of contract arising out of Mabanaft’s formal suspension or obligations and its refusal to perform the contract without the required payment security being in place.
In April of this year, the Harris County District Court awarded judgment in favor of Mabaneft and ordered OEC to pay $523,842,849.19 in damages plus post-judgment interest to Mabanaft. We note that OEC’s lawyers have indicated that the buyer intends to appeal.2
Irrespective of the ultimate outcome of the Mabanaft case, the underlying facts and circumstances provide several important lessons to U.S. sellers that are new to dealing with emerging market buyers.
This article will now examine some lessons learned from the facts in the Mabanaft case, and will discuss three important aspects to structuring the appropriate contractual payment security protections. While this article examines the payment security that may be required by a seller, our analysis applies equally to payment security that a buyer may require from a seller in the appropriate circumstances, as in many cases the buyer also faces potential losses if the seller fails to perform.
The “Right Size” of Payment Security
The foremost consideration with any contractual payment security arrangement is to ensure that the “right size” of payment security is required. As often seen in longer-term transactions, the seller in Mabanaft utilized two separate payment security mechanisms. The first, the SBLC, is typically intended to cover the seller’s potential losses if the buyer fails to perform its obligations for the entire duration of the contract. The second, the DLC, covers the buyer’s short-term obligations – in this case, the buyer’s payment obligations for each individual cargo.
The appropriate amount of each of these long-term payment security devices in any transaction will, of course, depend upon the creditworthiness of the counterparty and the nature, duration and size of the underlying transaction, as well as the relevant company’s internal credit risk assessment procedures and policies. That being said, certain basic factors are generally considered.
For long-term payment security, the amount should be designed to cover, as much as possible, the non-defaulting party’s aggregate potential damages and the seller’s corresponding mitigation costs in case of a default by the buyer on the entirety of its purchase obligations over the term of the contract. This amount ideally should take into account certain mitigating factors, such as the anticipated period of time required for the seller to procure a replacement buyer, as well as any potential changes to the commodity price following the buyer’s breach of contract.
More importantly, unlike in Mabanaft, the amount of required payment security can be based on a pre-agreed formula or indexed to certain market prices, which ensures that the required payment security amount is updated from time-to-time over the life of the contract. This type of floating payment security amount is also arguably more fair to both parties in that it should help protect the seller against future market price increases and reduce the amount of payment security required of a buyer if future commodity prices should decrease.
Similarly, the amount of short-term payment security (sometimes referred to as “liquidity support”), which can be provided in the form of a DLC (as in Mabanaft) or by way of an SBLC or an advance or escrow payment, is often tied to the anticipated contract price to be paid by the buyer for a designated cargo or number of near-term cargoes. Since this form of payment security is usually required to be in place before the subject cargo or cargoes are loaded, which is typically before the time that the full contract price for the cargo can be reliably calculated if a published index price mechanism is used, the amount of short-term payment security may be further increased by an agreed margin in order to cover any potential interim price movements or uncertainties, as well as to cover potential operational differences in physical deliveries.
For example, payment security intended to cover an upcoming cargo may be for 110% of the estimated contract price payable for that cargo. The additional ten percent cushion would cover any pricing movements between the estimated cargo value and the eventual definitive contract price for that cargo, as well as cover any actual overages in the quantity delivered or other fees and charges that may be included in the invoice payable by the buyer.
The “Right Timing” for Obtaining Payment Security
Another important consideration is the “right time” that the buyer should be required to make the specified performance security available to the seller. In this vein, it is important to note that in the Mabanaft case, even if the seller succeeds on appeal, the failure by the buyer to procure even the threshold-level SBLC by 90 days before the delivery start date means that the seller’s $523.8 million damages award against the buyer is wholly unsecured.
Ideally, any long-term payment security should be in place either at the original signing date for the contract (the best practice) or, by the latest, at such time that the parties’ respective performance obligations first become legally binding and enforceable, even where the parties’ actual performance may not begin until a later date. While the latter case is perhaps more typical in term contracts where there is a significant time period between the signing of the contract and the start of performance, the Mabanaft case illustrates the risk that a term seller takes if the payment security is not in place at the time the contract is originally signed. In the interim period between signing and the start of performance, the buyer may file for bankruptcy, suffer adverse credit downgrades or, as in Mabanaft, simply fail to provide the contractually required payment security before performance is to begin.
In many of the more sophisticated term contracts in the energy commodities sector, the parties’ respective performance obligations are often subject to each of the parties’ respective satisfactions of certain very specific conditions precedent. In these types of contracts, the provision of the buyer’s payment security is typically not required until such time that the conditions precedent are fully satisfied and the parties’ respective performance obligations have thereby become binding. In such cases, the obligation of the buyer to provide payment security may be stated either as a specific condition precedent itself (arguably the better practice), or by way of a separate contractual performance covenant, the compliance with which by the buyer is expressly stated to be a fundamental condition to the seller’s obligation to perform the contract.
The potential issue with the former “conditions precedent” approach is that, prior to the satisfaction of all conditions precedent, the buyer may walk away from the contract by not providing the required payment security. In such a case, the seller will be stranded with a potentially significant damages claim, but without any practical recourse if the buyer does not independently have the financial means to pay any resulting damages award. In contrast, if the buyer is obligated to provide payment security upon the signing of the contract, and the buyer subsequently fails to perform its obligations under the contract, the seller should then have recourse for the buyer’s breach or default (assuming the size of the payment security was sufficient).
The “Right Form” of Payment Security
Last, and no less important, is the “right form” of payment security. For long-term payment security, the most common options, and their respective pros and cons, are described below:
- Parent Guaranty. In many cases, a parent or affiliate of the buyer will separately agree with the seller that such entity will pay or perform the contract in the event that the buyer fails to do so. Unless the guarantor maintains an internal company policy to “charge” its subsidiaries or affiliates for credit support, there is typically no third-party cost involved with the provision of a parent guaranty as, at most, the guaranteed obligation is simply reserved as a contingent liability on the guarantor’s accounting records if so required by accounting rules.
The scope of coverage of the guaranty, and the triggers to the guarantor’s obligation to pay the seller, will be expressly set out in the guaranty, but at a minimum the scope of the guaranty should cover all payment obligations of the buyer to the seller under the contract. In terms of an emerging market buyer, the parent guaranty may not be useful where the buyer’s parent or affiliate companies have limited or no assets in jurisdictions where enforceability against such guarantor and its assets is readily accessible.
- SBLC. An SBLC is usually an instrument issued by a financial institution as payment security for certain potential payment obligations of its banking customer (typically referred to as the “applicant”), which in our setting would be the commodity buyer. Functionally, the SBLC acts very much like a guaranty, but the payment obligation under an SBLC is directly backed by the issuing financing institution, and the SBLC is legally and factually a separate and independent contractual obligation of the issuing bank – i.e., it is not affected by any potential defenses a buyer may have to payment under the commodity sale and purchase contract for which the SBLC serves as security. If the buyer fails to pay amounts due to the seller under the commodity contract, the financial institution is simply required under the SBLC to pay the amount claimed by the seller upon the presentation of documents specified in the SBLC.
The buyer-applicant will typically incur fees to the financial institution for the issuance of the SBLC, which in some cases can be as high as 3% or more of the face value of the SBLC. An SBLC is specifically limited to the amount, duration and draw conditions that are specified in the body of the SBLC, so the seller and buyer must expressly agree to the appropriate specific face amount (see discussion under “Right Size” above), which amount will not change while the SBLC remains in force, unless such SBLC is amended or replaced by an instrument covering a new face amount. Perhaps more importantly, any purported drawing conditions that are set out in the underlying commodity sale and purchase contract, but that are not also specifically contained in the body of the SBLC, will not be honored by the issuing financial institution. Thus, the parties should ensure that any conditions in the contract are reflected in the SBLC.
- Escrow Account. An escrow account is an arrangement with an escrow agent (and its related bank) where the buyer deposits a specified amount into a designated trustee-managed bank account, and the trustee of the account will then disburse payments from such account upon the instructions and conditions specified by the seller and buyer in the underlying escrow agreement.
There are third-party costs associated with an escrow account, but such costs are typically lower than that of an SBLC as the funds are already in the escrow account and, thus, the trustee is not exposed to any payment or funding risk relating to the buyer. Accordingly, a buyer providing payment security in the form of an escrow account must agree (and have access to) the amount to be deposited into the escrow account and such deposit will be required to be made as a condition to the seller’s obligation to perform the underlying commodity sale and purchase contract.
The typical forms of short-term payment security, and their respective pros and cons, are described below:
- DLC. A DLC is also commonly known as a “commercial letter of credit.” To draw on a DLC, the seller must present documents specified in the DLC, typically documents such as bills of lading to confirm the seller has performed its contractual obligations and thus has met the conditions for receipt of payment. Unlike an SBLC, the DLC is used as the primary and direct form of payment –i.e., upon delivery of the required commodity to the buyer, the seller will collect payment directly from, and draw upon, the DLC.
- SBLC. In addition to the summary of SBLCs set out above, it is important to note another key difference between an SBLC and a DLC. Where a DLC typically covers the price due on a particular delivery or deliveries, the SBLC has broader utility. Because an SBLC can be (and very often is) used to cover any and all non-performance by the relevant counterparty, it can be used to cover other contingent liabilities that such non-performing counterparty may owe under the contract, and not merely the amount of a particular delivery of commodities.
- Prepayment. Prepayment would be the simplest form of payment security for the seller if the parties can agree on the prepayment amount and terms. The buyer is unlikely, however, to agree to any prepayment above the anticipated invoice amount – i.e., the commodity product quantity multiplied by the contract price. Thus, the seller may remain exposed where there are other fees and charges that are assigned to the buyer but which may become known only after the completion of delivery, such as any port charges, taxes and export duties and excess berth charges that the buyer fails to pay (and which may be sought from the seller). Any prepayment that is designed to cover all of these potential buyer payment items will likely require subsequent reconciliation, and thus a bit more administrative burden on the seller.
U.S. energy commodity sellers are more frequently looking abroad for rebound and growth opportunities. In doing so, they may be dealing with less familiar or unfamiliar counterparties, and they may very likely be dealing with payment and performance risks that such sellers may not have faced before.
As a result, these U.S. sellers should give careful consideration to structuring the appropriate type and amount of payment security, as well as to making sure that such payment security is furnished at the appropriate time, in order for such sellers to strengthen their respective positions to ultimately collect on the economics of the deals they have struck with today’s emerging market buyers.