A natural standard 1

Commodities trading

The aim of this article is to highlight the need to reassess the documentation upon which physical commodities are traded in the two primary European physical gas hubs: the National Balancing Point in the UK and the Zeebrugge Hub in Belgium. This need is particularly pressing in light of the Enron and TXU Europe experiences. One tool that is available to commodity traders is the European Gas Annex 2 published by the International Swaps and Derivatives Association (Isda) 3 (the ‘Annex'). The Annex allows traders to put their entire portfolios, both physical and financial, under one common platform backed by legal opinions and collateral documents, and stress-tested in a variety of markets and conditions. However, the authors have found that there is both little literature on the Annex, and many misconceptions about the need for it and how it functions. This article will explore why the Isda Master Agreement (Multicurrency-Cross Border) (the ‘1992 Isda') and/or the Isda 2002 Master Agreement (the ‘2002 Isda' and with the 1992 Isda, the ‘Isda' 4) was chosen as the platform, and, equally importantly, why a common platform can and should be used to trade physical and financial products. We will focus on the advantages of single-agreement architecture and the mechanics of the Annex itself, particularly its interrelationship with the Short Term Flat NBP Trading Terms and Conditions (the ‘NBP') and the Zeebrugge Hub Trading Terms and Conditions (ZBT 2001) (the ‘ZBT'). Included in this analysis is a discussion of the basis risk that exists and will continue to exist as long as some trades are conducted under the Annex and others remain outside of it. Our aim is not to portray the Annex as a panacea, but rather to present it as one viable solution that is available for lawyers, traders and credit officers who wish to better manage counterparty and market risk in a more standardised manner than is at present the norm.

Too many cooks: why Isda was chosen as the platform

The Annex was published by Isda in March 2003. The purpose of the Annex is to provide a vehicle to bring both existing and future forwards and options under the NBP and the ZBT within the framework of the Isda. The principle driving force behind the creation of the Annex lay in the need for updating the NBP and ZBT coupled with a desire to reduce the plethora of agreements upon which counterparties trade. 5 This problem is particularly glaring in the continental European natural gas market, where each gas hub has its own set of documents and trading terms. The result of this hodgepodge of documentation is not only a high barrier to entry, since considerable time and money must be spent to tailor each set of terms to each counterparty, but also different types of legal and credit risk. These risks stem from the fact that multiple agreements between two given counterparties may have widely differing sets of credit/tax/close-out and governing law provisions despite the fact that from a credit perspective the risk between the two parties is unaffected by the document upon which trading occurs. Compounding this multiplicity of documentation is the fact that many of the agreements are orphaned in the sense that they have no backing associations to co-ordinate regular updates to them to reflect market changes, and obtain legal opinions on their efficacy. The NBP is a perfect illustration in that it was published in 1997, and has not been revised or reissued since that time. Thus, while the NBP remains interesting from an historical perspective as the founding trading terms of UK gas, its provisions now ignore the options market, the rise of single-agreement architecture and even such mundane matters as the Contracts (Rights of Third Parties) Act 1999.

By contrast with the NBP/ZBT, the Annex has a permanent sponsor, Isda, which continually updates and revises its documentation and supports it with netting and collateral opinions. The Isda is but one part of the documentation library that can be used in conjunction with other important tools including the Credit Support Annex/Deed, the 1993 Commodity Definitions published by Isda as supplemented by the 2000 Supplement to the 1993 Definitions (the ‘Commodity Definitions') 6, annually updated netting and collateral opinions, and a large collection of litigation precedents giving an indication of how the Isda provisions will react to stress testing. By contrast, there are few if any litigation precedents for the NBP/ZBT. Alongside this library, the other factor that promotes use of the Isda over competing master agreements is its widespread use in other commodity markets, particularly oils and metals. Many of the participants in the natural gas market also trade some or all of the other commodities already documented under the Isda, including power, weather, freight, coal and emissions, and so are familiar with the workings of the Isda 7. This means that the ‘multiple documentation disorder' 8 is to some extent blunted.

The tension between the Isda and physically settled products: a parochial myth

One of the main barriers to trading any physically settled commodity under the Isda is a widespread sentiment that the Isda caters only for financial transactions, and minimises or ignores the physical aspect. For example, the Commodity Definitions currently focus solely on cash-settled trades. As a result, it is argued that trading physically settled products makes wholesale changes to the Isda unavoidable. The need for such changes stems from a belief that each market requires unique sets of terms and definitions to deal with that market's idiosyncrasies.

Alas, this myth is ultimately false. In reality, the topic of physical trading under the Isda is not new. Indeed, as far back as 1993 lengthy consideration was given to the provisions required for physical settlement9. That further amplification of this theme is absent from the Commodity Definitions is probably due more to the fact that in 1993, when the original definitions were published, NBP and ZBT did not exist. Now that the NBP and ZBT have matured into full-fledged liquid markets attracting interest from new quarters, the need for standard documentation should be seen as tribute to the market's growing strength rather than a sinister takeover attempt. That said, there is a kernel of truth to the argument that NBP/ZBT have much bespoke jargon that does lead to a need for change or addition to the standard Isda. Were this not true, there would be no need for the Annex or for this article! However, we believe that the required additions are not radical. The most prominent difference between physical and financial trading is the presence of delivery risk in the former. Delivery risk is already envisaged in various sections of the Isda 10, and the relevant terminology from the NBP/ZBT can be incorporated where needed. Leaving aside the many jargon-filled pages of the operational guides such as the Network Code and the Hub Services Agreement, which, at any rate, are at best incorporated by reference into the NBP and ZBT, the amount of terminology required is not as great as is commonly imagined. Much of the language used in physical trading agreements covers concepts that are not unique to any one market, that is, events of default, notice mechanics, governing law, etc. It is from focusing on these similarities that the Annex takes its cue since, ultimately, the transactions covered by the NBP and the ZBT offer a risk/reward ratio that is not hugely different from that involved in a classic financial product such as a trade on an oil index, and those risks should, where similar, be dealt with in a like manner.

E pluribus unum: single agreement versus trading terms

The NBP, as its formal title suggests, is a set of trading terms and does not attempt to bind together trades into a single agreement. This means that NBP trades (i) stand on their own, (ii) are without netting on close-out and (iii) that a default or force majeure in respect of the NBP must be declared individually for each transaction. The effect is to mandate that counterparty exposure be looked at on a gross basis, and, depending on the insolvency regime, may allow an insolvency official to ‘cherry-pick' in-the-money transactions. This leads to wholly avoidable credit and legal risk. The most important benefit of changing the NBP, as well as to a lesser extent switching from the ZBT 11, to the Annex is the benefit afforded by the single-agreement architecture. Section 1(c) of the Isda makes clear that all transactions under it form a single agreement. This means that (i) exposure may be monitored on a net basis, which has the advantage of freeing credit lines 12, and (ii) counterparty exposure in the event of a default-type situation will be reduced, coupled with a greater certainty of the amount of damages recoverable for close-out. The single-agreement approach means that in most cases under the Isda 13 a default or termination of one transaction leads to a termination of all transactions, which allows a party to quickly and easily limit its exposure. Administratively, the benefits of having to issue one notice per counterparty, rather than one notice per trade or per product-specific master agreement, are huge, particularly where, as is almost always the case in insolvency situations, time is of the essence.

Not reinventing the wheel: incorporation of NBP and ZBT terms

In designing the Annex, it was clear that although certain weaknesses existed in the NBP/ZBT, other parts have functioned well. Moreover, from a practical standpoint in the years since the NBP/ZBT were issued, a familiarity and attendant body of knowledge and procedures has grown up among market players. It was strongly desired that rather than ignore this foundation, the Annex should leverage off of it by incorporating the NBP and ZBT as they existed in March 2003 14 into the Isda. This is the function of Parts [6 and 7](a) and (c) of the Annex. Parts [6 and 7](a) incorporate the NBP/ZBT while Parts [6 and 7](c) list those clauses that are applicable under the Annex.

The bulk of the NBP/ZBT sections that are applicable under the Annex are concerned with the operational mechanics15. By incorporating the NBP/ZBT directly into the Isda, the danger of basis risk is minimised between those trades that were affected pre-Annex and those that are post. This is key since any change in the operational provisions of the NBP/ZBT, that is, the way transactions are confirmed and notified or the billing process, would create a plurality of operating procedures which would be difficult (and expensive) for a user's back office to oversee.

As important as what the Annex makes applicable are those sections of the NBP/ZBT that are left out by it. The Annex deletes most of the ‘legal boilerplate' provisions (for example, entirety of agreement and no waiver provisions). Since these provisions already exist in the Isda, it was felt that duplication should be avoided and so the redundant clauses in the NBP/ZBT no longer apply. Table 1 below lists those clauses in the NBP/ZBT that are accordingly disapplied in Parts [6 and 7](c) of the Annex and where the replacement section can be found under the Isda.

Table 1: Deleted clauses in the Annex and their Isda equivalents

Clause function
NBP disapplied Clauses
ZBT disapplied Articles
1992 Isda equivalent sections
2002 Isda equivalent sections

Assignment

9
12
7
7
Confidentiality
8
11
Dispute resolution
22
13(b)
13(b)
Entirety
14
17
9(a)
9(a)
Events of default
10.1, 10.2, 10.4
13.1, 13.2, 13.4
5(a), (b)
5(a), (b)
Governing law
17
21
13(a)
13(a)
Liabilities
11
14
[6(e)(iv)]
[6(e)(iv)]
Notices
16
19
12
12
Severability
15
18
Variation
13
16
9(b)
9(b)
Waiver
12
15
9(f)
9(f)

Of the deleted clauses, there are three that are worth highlighting. The first concerns dispute resolution mechanics. The NBP is silent on this topic. However, the ZBT favours arbitration while the Isda opts for a court-based solution. 16

The second area of interest is notice mechanics. To ensure that back-office procedures can be streamlined and different notice rules do not have to be followed for every type of trading that a user engages in, the standard Isda notice provisions are used. This change will alter when notice is regarded as effective and what types of notice are eligible. The Isda also contains a much wider list that more accurately reflects the methods by which companies communicate in 2004 than either the NBP or ZBT.

The third type of clause that is left out of the Annex is the confidentiality clauses of the NBP/ZBT. The Isda lacks any specific confidentiality provisions, in stark contrast to the NBP/ZBT. The NBP/ZBT, reflecting a heritage from upstream deals, contain confidentiality wording. We express no view on whether such a provision is needed but would note that both Clause 8 of the NBP and Article 11 of the ZBT contain numerous carve-outs that give them a sieve-like quality 17 that may not be entirely appropriate for sensitive deals. Confidentiality provisions can be reincorporated back into the Isda without greatly affecting the operation of the document and the decision is ultimately up to the user.

Clarifying defined terms

The Annex incorporates the definitions provisions in Clause 1 of the NBP and Article 1 of the ZBT. Annex users should be aware that the definitions used there overlap to a certain extent with definitions found in Section 14 of the Isda. The overlapping terms under the NBP are ‘Affiliate', ‘Confirmation' and, in the case of the 2002 Isda only, ‘Force Majeure'. Under the ZBT, the overlapping terms are ‘Affiliate', ‘Confirmation', ‘Loss' and ‘Tax'. The differences between these terms as they appear in the NBP/ZBT and in the Isda are not major, but we would suggest that, to avoid any confusion, parties using the Annex specify that the overlapping terms be understood to have the meanings accorded them under Section 14 of the Isda. If this step is not taken, the definitions in the NBP/ZBT Terms will prevail. This may not be desirable, especially in conjunction with the concept of ‘Affiliate', where users will want to know at all times what parts of their own or a counterparty's group are caught by the relevant Isda provisions, and monitoring a single definition of affiliate may well be easier than monitoring multiple ones.

Governing law

The Isda can be concluded under the laws of England and Wales or the State of New York (NY) 18. Although the choice of governing law is left to the contracting parties, a choice of any other governing law will be outside the scope of any backing legal opinions provided by Isda. The effect of this limitation is felt principally in connection with the ZBT where the governing law is changed from Belgian law 19 to either English or NY law 20. This article makes no recommendation as to whether English or NY law is more desirable, but it must be emphasised that in switching governing law from X to Y certain basis risk may arise. This is principally seen in the ZBT in relation to insolvency21 and force majeure.

The full quiver: events of default/termination events

Perhaps the greatest change between the Annex and the NBP/ZBT is in the area of default triggers, especially when combined with the effect of single-agreement architecture (see above). The NBP/ZBT have a unicameral system of defaults whereby all events that allow close-out of a transaction under the NBP/ZBT are treated as events of default. These events set out below (see table 2) largely (though by no means faithfully) track Section 5(a) of the Isda. The Isda, by contrast, has a much more extensive bicameral selection of Events of Default (EoD), which allow close-out of the entire agreement, and Termination Events, which close-out only Affected Transactions, as defined under Section 14 of the Isda. Furthermore, the Isda, unlike the NBP/ZBT, also incorporates the idea of potential EoDs that allow parties to pick up on early warning signs regarding a counterparty's possible financial decline and to cease payment/delivery.

Table 2: Events of default/termination events: NBP & ZBT vs the Isda (without the Annex)
Clause function
1992 Isda section
2002 Isda section
NBP Clause
ZBT Article
Bankruptcy
5(a)(vii)
5(a)(vii)
10.1.1
13.1.1
Breach of agreement/transaction
5(a)(ii)
5(a)(ii)
10.2.1
13.2.1
Credit event upon merger*
5(b)(iv)
5(b)(v)
-
-
Credit support default
5(a)(iii)
5(a)(iii)
10.1.3
13.2.3
Cross default
5(a)(vi)
5(a)(vi)
-
-
Default under a specified transaction
5(a)(v)
5(a)(v)
-
-
Failure to deliver
5(a)(i)
5(a)(i)
Failure to pay
5(a)(i)
5(a)(i)
10.2.2
13.2.2
Force majeure
-
5(b)(ii)
-
-
Illegality*
5(b)(i)
5(b)(i)
-
-
Misrepresentation
5(a)(iv)
5(a)(iv)
10.1.2
13.1.2
Material adverse change
-
-
10.1.4
13.1.3
Merger without assumption
5(a)(viii)
5(a)(viii)
-
-
Tax event*
5(b)(ii)
5(b)(iii)
-
-
Tax event upon merger*
5(b)(iii)
5(b)(iv)
-
-

* = Termination event

As the table above illustrates, the EoDs/termination events under the Isda are far greater in number than those found under either the NBP or ZBT. However, what the chart does not convey is that they are also of far greater breadth. The differences can be of major consequence to a party's termination rights. Insolvency is a prime example of these differences as Section 5(a)(vii) of the Isda is much broader and more sensitive than the corresponding NBP/ZBT provisions as it captures most forms of insolvency-related events 22 in many jurisdictions including failure to pay debts as they become due, self-institution of insolvency proceedings/petitions, and a secured party taking possession of the defaulting party's assets.

It is beyond the scope of this article to go into each of the events under Section 5 of the Isda23. However, generally speaking, the Isda tends to provide for shorter grace periods 24, caters to more numerous types of risk including tax and change in company structure risk, and has broader insolvency provisions than the NBP/ZBT. The effect of this approach is to give Annex users a much larger and more refined arsenal of credit and legal triggers than would otherwise be available.

In designing the Annex, it was recognised that the events found under Section 5 of the Isda required some supplementation to address the peculiar aspects of physical trading particularly in respect of operational risk. To this end, the Annex introduces several new EoDs and Additional Termination Events (“ATE”). These are set out below in table 3. Interestingly, the additional EoDs and ATEs in the Annex are expressly aimed only at NBP/ZBT transactions rather than including NBP/ZBT options as well. The reasons for this omission are obscure and we can see no reason why NBP/ZBT options should not be covered.

Table 3:Additional events of default and additional termination events added by the Annex
Clause function
Annex (NBP provisions)
Annex (ZBT provisions)
Breach of ZBT/NBP terms [6](d)(i)(aa) [7](d)(i)(aa)
Breach of ZBT/NBP terms* [6](d)(ii)(aa) [7](d)(ii)(aa)
Force majeure [6](d) [7](d)
Material adverse change [6](d)(i)(bb) [7](d)(i)(bb)
Misrepresentation* [6](d)(ii)(bb) [7](d)(ii)(bb)
* = Termination event

i) Breach of NBP/ZBT terms

This event is designed to cover a ‘material' breach of the NBP/ZBT terms. The nature of what is material is left undefined except that it is stated to include ‘persistent' failure to make a trade nomination. The defaulting or affected party (depending on whether this is treated as an EoD or ATE) is given one NBP banking day/one working day 25 to remedy the problem after receiving notice from the other party. This clause, like its forebears in the NBP/ZBT, is weakened by the absence of certainty around the central concept of materiality and the ancillary term ‘persistent'. This lack of clarity is unsatisfactory but probably unavoidable given that agreement on, or enumeration of, what is material is almost impossible. Nonetheless, users should be aware that this subjectivity makes the clause both easier to trigger and easier to challenge on the grounds of misapplication.

The Annex also gives users the choice between categorising breach of NBP/ZBT terms as an EoD or an ATE. However, regardless of whether an ATE or an EoD is elected, a breach will lead to a termination of all transactions both within and without the Annex so long as they are under the Isda in question.26 Thus, the operational risks of a material breach in the NBP/ZBT are not ‘siloed' from other risks without further adjustment. This may be of some importance to parties that wish to use the Isda to trade a variety of products where risk of an NBP/ZBT terms breach may not justify terminating the relationship as a whole. This inability to isolate risks is frequently cited by some counterparties as a reason for avoiding use of the Annex. However, this so-called portfolio default risk can be minimised through amending the definition of ‘Affected Transaction' in Section 14 of the Isda to state that for purposes of ATEs under the Annex, the sole affected transactions shall be NBP/ZBT transactions. This will prevent an NBP/ZBT operational default from closing out any non-affected transactions. 27 Users should also be aware that the choice between an EoD and ATE may have other ramifications including the availability of the enforcement indemnity under Section 11 of the Isda, which applies only to EoDs, as well as affecting the potential for an event to be caught by specified transaction default clauses in non-Isda agreements such as loans or offtake contracts.

ii) Breach of NBP/ZBT terms versus Breach of Agreement

Breach of NBP/ZBT terms and Breach of Agreement under Section 5(a)(ii) of the Isda perform similar but subtly different functions. Parts [6 and 7](d)(iv) of the Annex state that whereas Section 5(a)(ii) of the Isda would normally cover a failure to accept, deliver, nominate or notify, it does not do so under the Annex. Here those events are covered by Breach of NBP/ZBT Terms. The coverage is not identical since to be a breach of the NBP/ZBT terms it must be a material breach. This differs markedly from Breach of Agreement, which covers any breach without regard to a materiality test. Moreover, the switch to Breach of NBP/ZBT Terms has a major impact on grace periods since Breach of NBP/ZBT Terms, with its one-day grace period, is far stricter than Breach of Agreement under the Isda, with its 30-day grace period. Arguably, this difference in grace period may be attributed to penalty costs under the Network Code and Hub Services Agreement that are associated with incorrect nominations and mean the stakes are higher than in a purely financial contract. Such costs can quickly aggregate, and can lead eventually to suspension or dismissal from the pipeline, an extreme consequence, but the costs of incorrect nominations or of failure to deliver/accept are very real. Users need to decide whether to use Section 5(a)(ii) or Breach of NBP/ZBT Terms based on an analysis of their operational risk thresholds and those of their counterparties.

iii) Misrepresentation

The NBP and the ZBT terms include similar representations relating to the fact that trading parties must hold and maintain any relevant licences and permissions as well as be members of either the Network Code in the case of the NBP, or the Hub Services Agreement in the case of the ZBT. Non-membership in these operational codes means that a party cannot trade. Parts [6 and 7](d)(vi) of the Annex state that representations under Clause 3 of the NBP and Article 6 of the ZBT are representations for purposes of the Isda and, if found to be untrue, constitute an EoD under Section 5(a)(iv) (‘Misrepresentation') of the Isda. 28 If this language clarifying the status of representations under the NBP/ZBT is not included in the Annex, parties may still wish to protect themselves against a counterparty failing to be in good standing with the relevant operational code via the Misrepresentation ATE in Parts [6 and 7](d)(ii)(bb) of the Annex.

If Annex users choose to make it an ATE to breach a representation in respect of either Clause 3 of the NBP or Article 6 of the ZBT, as noted above, parties need to consider the consequences of the choice between an EoD and an ATE. Given the vagaries and operational complexities associated with compliance with the Network Code and Hub Services Agreement, it may well be that parties wish to isolate this risk by changing the definition of ‘Affected Transaction' in the manner outlined above.

iv) Material adverse change

The Annex, mirroring its purely physical gas brethren, gives the user the option of including an additional EoD covering a material adverse change (MAC). The MAC is triggered if there is a MAC in relation to a counterparty's financial standing that affects its ability to perform its financial obligations in respect of NBP/ZBT trades. The decision of whether a change is material or not is left entirely to the discretion of the non-defaulting party, whose decision-making ability is unfettered by such limitations as reasonableness. As in Breach of NBP/ZBT Terms above, no guidance is given as to the meaning of ‘material'. It should also be noted that the clause assesses the occurrence of the MAC by reference to the trade date, not to the date on which the Annex or the Isda was agreed. The scope of the MAC is also limited to the financial standing of the party and ignores the standing of any credit support provider.

If the non-defaulting party decides such a MAC has occurred, then the defaulting party has two NBP two banking days/two working days to provide reasonable security for performance of its financial obligations. What is meant by reasonable security is unclear, that is, is it limited simply to the amount of exposure, or would it be reasonable for a party to demand a further margin on top of that exposure, and, if so, how large a margin can be demanded. As to the forms of security that may be provided, the EoD is purposefully vague, allowing parties the maximum number of options, for example, extra collateral under a credit support annex, provision of a parental company guarantee or a letter of credit.

The authors would recommend that the inclusion of a MAC as an additional EoD be considered with care. The MAC is a very wide clause the parameters of which are ill defined and, as noted above, this lack of definition gives it tremendous flexibility making it a tempting choice for a non-defaulting party to call. The flipside of this is that it is also vulnerable to challenge on the grounds of misapplication especially where the materiality of a particular change is contentious 29. If this EoD is included, the clause should at least be clarified (i) by listing what types of extra security are acceptable to avoid any danger that the Non-Defaulting Party is forced to accept security, which though in a reasonable amount is in a form which is not preferable, and (ii) through the use of objective, ratings-based triggers.

The three force majeure regimes: NBP, ZBT and Isda

i) NBP/ZBT Force Majeure and the 1992 Isda

When using the Annex in conjunction with the 1992 Isda, force majeure (FM) can be adopted wholesale from the NBP/ZBT Terms without fear of conflict with existing provisions in the 1992 Isda. This is because the 1992 Isda contains no FM provisions of its own (see table 3 above). Despite this, parties still need to consider how they wish FM to operate, that is, should the declaration of FM be an EoD, a termination event or a no-fault termination. This is the thrust of Part [6](d)(v), which asks users to consider whether they wish FM to be a termination event with two affected parties, and whether they wish it to be capable of triggering a termination payment. The notion of payment upon FM represents a substantial break with the NBP and ZBT where FM leads to a ‘walk-away' situation where neither party will receive any compensation in respect of the remaining contract value of the affected transactions. We would invite Annex users to consider whether such a walk-away approach truly encapsulates the commercial reality of the situation. Making this election must be balanced against the basis risk with NBP trades outside of the Annex for which no payment will be due upon occurrence of FM.

ii) NBP/ZBT force majeure and the 2002 Isda

By contrast with the 1992 Isda, the 2002 Isda includes FM provisions under Section 5(b)(ii). Users who plan to place the Annex under the 2002 Isda need to be aware of the possibility of conflict between the differing FM regimes under the 2002 Isda, the NBP and the ZBT.

The coverage of FM under the 2002 Isda is much broader than that found under the NBP, but is arguably narrower, than that under the ZBT. It should be noted that FM under the 2002 Isda applies to all trades under the Isda, but under the NBP and ZBT, without alteration, FM arguably applies only to forwards since the concept of options is non-existent under those agreements. FM under the 2002 Isda covers any event beyond the control of a party that prevents payment/delivery, or performance under a credit support document. By contrast, FM under the NBP is focused exclusively on an inability of a party or Transco to make trade nominations. In further contrast with the Isda 2002, ZBT FM focuses on whether, using the reasonable and prudent operator concept, a party can fulfil its obligations under the ZBT. ZBT FM is also broader than the 2002 Isda covering both events affecting the party itself and events affecting facilities immediately upstream or downstream of the Zeebrugge Hub. These differences in scope are in addition to the different waiting periods before closing out transactions that exist between all three regimes and, hence, can lead to instances where FM may be declared under one regime but not the others.

There is also basis risk as to timing of FM. Under the 2002 Isda, FM is only triggered after the exhaustion of all available disruption fallbacks 30. The NBP/ZBT contains no such provision. Thus, Annex users need to be aware that if they include disruption events under the Annex they may delay the application of FM under the 2002 Isda.

One approach to reconciling the three differing FM regimes under the Annex is to harmonise the timing of their application. This may be done through characterising NBP/ZBT FM as the first applicable disruption fallback under the 2002 Isda. This will allow FM under the 2002 Isda to be declared at the same as under transactions outside of the Annex. Alternatively, parties may simply disapply FM under the 2002 Isda in favour of FM under the NBP/ZBT in which case basis risk is avoided, but may inadvertently be created between Annex transactions and the rest of the Isda portfolio especially between NBP Transactions and other Isda trades. This is because NBP FM ignores ability to pay whereas 2002 Isda FM focuses on it.

Tax

Reflecting a general energy trading laissez-faire approach to change in tax risk, both the NBP and the ZBT are silent on the subject, providing no defence against either domestic or cross-border tax liabilities. This attitude is in stark contrast to the Isda, which covers Tax Event 31 and Tax Event Upon Merger 32. Given the Isda does contain tax language, the question is whether that language addresses the types of tax risk which are inherent in trading under the NBP/ZBT. The Isda focuses mainly on direct tax risk such as withholding tax. Under the Annex, users need to ask whether this focus should be widened to include the risks of indirect taxation such as VAT and environmental levies 33. Arguably, the Isda tax provisions would benefit from refinement to ensure that they are not too easily triggered by events such as a change in the rate of VAT 34. Alternatively, there may be certain types of tax risk such as environmental levy risk that are peculiar to NBP and ZBT, and thus might warrant the creation of specific ATEs within the Annex, or expansion of the definition of ‘Indemnifiable Tax' under Section 14 of the Isda.

Looking to the future, it may be that the tax-related representations given under the Isda need to be updated to reflect the Council Directive 2003/92/EC amending Directive 77/388/EEC. This Directive changes the VAT charging jurisdiction from the place where the gas is physically located to the place where it is consumed, that is, in the case of the Annex to the place where the Buyer is located. This combined with the introduction of the concept of ‘taxable dealer' may mean that parties require specific VAT-related tax representations in connection with the trading of physical commodities.

Options

The Annex, in recognition of the growing options markets in both the NBP and ZBT, introduces a set of standard terms and mechanisms for dealing with options. This is the function of Parts [6 and 7](g) of the Annex. Those sections give the definitions for such basic concepts as put, call, American and European option, as well as provide mechanics for option premium payment, option exercise and option default. This is complemented by the presence of the Annex of a sample options confirmation. The mechanics of the options language are fairly similar to those found elsewhere under the Isda nomenclature. The main areas of concern in documenting options are applicability of VAT, automatic exercise and late payment. Of these, perhaps the most difficult to analyse is the role of VAT. The option may attract VAT since it is an option to enter into a physical trade. Unfortunately, in respect of VAT there is no single rule since the applicability of VAT in cross-border transactions is directly tied to the location of the parties. Users should seek advice on this point. In relation to automatic exercise, parties need to ask of themselves whether their operational departments are comfortable with always exercising in-the-money options given that such exercise will bring with it nomination duties and other operational responsibilities. Finally, in relation to late payment, parties need to decide whether they wish to accept late payment, treat the late payment as creating a voidable option or as a failure to pay under Section 5(a)(i) of the Isda. We would note that adding optionality in the case of late payments may increase a party's flexibility at the expense of certainty, which may not always be desirable from a credit risk standpoint.

Getting full value: close-out mechanics under the Annex

When closing-out a party under the Annex, the key question is how to value the affected forwards and options. The choices for valuation under the Annex depend on whether or not the transaction in question is an option or a forward. For options, the Annex adds no special close-out mechanics 35 meaning that by implication termination payments are calculated under the Close-Out Amount methodology under the 2002 Isda, or under the method selected by the parties under Section 6(e) of the 1992 Isda, that is, First vs. Second Method, Loss vs. Market Quotation.

In relation to the valuation of forwards, the Annex offers users a choice between retaining the valuation mechanics found under Clauses 10.5 and 10.6 of the NBP and Articles 13.4 and 13.5 of the ZBT 36, or switching to Isda calculation mechanics. The switch is a crucial one since the quantum arrived at under the various methodologies may vary significantly. In general, the close-out valuation methodologies of the NBP/ZBT are more prescriptive and, when compared with loss and close-out amount under the Isda, offer the non-defaulting party less ability to take into account associated costs such as cost of funding or loss of hedging.

(i) NBP transactions

Clause 10.5 of the NBP calculates the close-out amount as the discounted difference between market value as defined by pre-selected indexes and the value of the remaining supply period of the transaction. This valuation focuses solely on the transaction and does not address concepts such as invoiced but unpaid amounts 37, counterparty/party creditworthiness, value of any credit support, cost of funding, and loss of hedging. This is in stark contrast to the Isda, which takes a much more holistic view of the value of transactions upon termination. This allows parties to arrive at a calculation that is much more representative of the true value of the transaction by including those concepts that the NBP neglects. This is key since it allows the preservation of the economic equivalent of the terminated transactions. It is possible should users so wish to utilise the same equations and indexes found under Clause 10.5 of the NBP in conjunction with loss under the 1992 Isda or close-out amount under the 2002 Isda. Both loss and close-out amount allow the non-defaulting party a great deal of latitude, so long as that party acts in a commercially reasonable manner, as to how the termination amount is calculated and what sources are used. If, however, market quotation is used, Annex users should be aware that, unlike Clause 10.5 of the NBP, recourse is to reference dealers not indexes, and the fallback is to Loss rather than ‘reasonable experts'. In addition, parties should understand there is a subtle difference between the expert method under the NBP and Market Quotation in that the highest and lowest quotes under the 1992 Isda are disregarded whereas as all expert quotes are used under the NBP regardless of the deviation between them.

(ii) ZBT transactions

Article 13.4 of the ZBT states that the close-out amount will be the net sum of the value of transactions and any unpaid amounts. The transactions are valued under Article 13.5 using a formula whose outcome depends on whether or not replacement transactions are entered into. If replacement transactions are agreed, then the value paid out is equal to the actual cost of replacement. If no replacement transactions are entered into, ZBT loss is used. Article 13.5 of the ZBT focuses exclusively on the termination value of the transactions without mirroring the Isda's attempts to preserve their full economic value. The Isda mechanics also do not change depending on whether or not a party chooses to enter into replacement transactions. Should parties wish, it is possible to mimic Article 13.5 using the loss or close-out amount method. If, however, market quotation is used, no such mimicking is possible since the quotations may or may not reflect the actual costs of entering into replacement transactions given that the Isda has a wider scope for what actual cost means.

(iii) Limitation of liability

The NBP/ZBT contain blanket prohibitions against the inclusion of consequential or indirect damages in the calculation of the termination payment. The NBP/ZBT include such provisions to ensure that parties cannot pass on indirectly related up/downstream costs connected to delivery and procurement of gas. Such concerns would have been prevalent in market players present at the creation of the NBP/ZBT since virtually all owned physical assets such as delivery networks or refineries 37. In our view, inclusion of Clause 11 of the NBP and Article 14 of the ZBT may sit uncomfortably with Isda termination nomenclature and may alter termination calculations under it. This is especially glaring in connection with the use of loss under the 1992 Isda because Section 6(e)(iv) of the 1992 Isda, which excludes consequential loss, expressly applies only to market quotation. In the case of market quotation or close-out amount the limitation of loss provisions under the NBP/ZBT will have less of an impact, but should not be disregarded entirely. We believe that the best method to handle this risk would be to import the limitation of liabilities provisions only if the original NBP/ZBT valuation methods are included under the Annex.

12. Risk management is everything

The Annex is one solution to the problem of weak documentation that has bedevilled physical gas trading. Today's reality, unlike in 1997 when the NBP was published, is that market players trade ever more products with a growing list of counterparties, which makes risk management paramount. There is a long list of companies who are no longer with us because they ignored this adage. Risk is present both in terms of a counterparty's financial health, and in terms of a party's own documentation. The stronger the documentation, the more certainty in turbulent times. The Isda, with its legal opinions and ubiquity throughout the commodity-trading world, is a sturdier aegis than either the NBP or ZBT. While the Annex is not perfect, we have attempted to show that approached with caution and understanding it is possible to be sensitive to the idiosyncrasies of physical trading while at the same time adopting the credit, tax and other protections that the Isda offers. We would hope that the Annex becomes a widely used tool as companies acquire greater awareness of its workings and the general need to have robust legal documentation. Ultimately, the success of the Annex will hinge upon its adoption by the very players who created the NBP/ZBT. This adoption will only materialise in conjunction with the acceptance that the unamended NBP/ZBT alone cannot meet the rising need to upgrade and standardise risk management techniques across a trading portfolio.

1 The opinions contained in this article are those of the authors' alone, and do not necessarily represent the views of the organisations for which the authors work. This article is necessarily general and is not intended to be comprehensive, nor does it constitute legal advice in relation to any particular situation.

2 Although officially titled the European Gas Annex, it is actually comprised of two annexes, one dealing with NBP and one dealing with ZBT. The two sections may be used together or separately.

3 International Swaps and Derivatives Association, Inc.

4 Throughout this article references to the Isda should be taken as references to both the 1992 and 2002 Isdas. Where the 1992 and 2002 Isdas diverge, the authors will explicitly state.

5 Currently, the NBP and the ZBT can be traded unamended, under bespoke amending agreements that turn them into master agreements, under the EFET CPMA NBP Amendment or under bespoke gas master agreements.

6 The Commodity Definitions are currently being revised and consolidated with an eye to bringing out a 2004 version.

7 Even where this is not the case, their Treasury departments will almost certainly have some experience of the Isda for hedging interest rate and currency risk.

8 Stephen R. Greene, Page 88, European Financial Services Law, July 1994, “Does your institution suffer from multiple agreement disorder?”

9 “The 1992 [Isda] Agreements….accommodate or facilitate…. the documentation of transactions providing for settlement by physical delivery.” Page 60, User's Guide to the 1992 Isda Master Agreements (1993 Edition) (the “ 1992 Guide ”).

10 These sections include Isda Sections 2(a), 5(a)(i), 5(b)(i) and in the 2002 Isda only 5(b)(ii).

11 The ZBT contains no explicit single agreement clause though much of its language seems to anticipate that it is in fact a single agreement.

12 Netting of exposure is dependant on the existence of a legal opinion backing the efficacy of netting in a particular jurisdiction.

13 Under the 2002 Isda certain Termination Events under Section 5(b) allow the non-affected party to terminate some but not all transactions.

14 It should be noted that Isda was not and is not responsible for the drafting or updating of the actual NBP or ZBT Terms. Should new versions of either of these agreements be published in the future, it may be necessary to revisit the Annex.

15 Clauses 1 (Definitions), 2 (Confirmation Procedure), 4 (NBP Trades), 5 (Contract Price), and 6 (Billing and Payment) of the NBP and Articles 1 (Definitions), 2 (Sale and Purchase Agreement), 3 (Warranty and Title), 4 (Quality), 5 (Confirmation Procedure, 7 (Transactions), 8 (Contract Price) and 9 (Billing and Payment) of the ZBT.

16 Although the Isda, as drafted, favours a court-based solution, counterparties can substitute arbitration mechanics without great difficulty should they so wish.

17 Usual carve-outs are public domain, professional advisers, government agencies, regulators, recognised stock exchanges, price reporting agencies, etc.

18 Pages 33-34 of the 1992 Guide notes parties may choose a law other than that of England or NY but should consult their legal advisors before doing so.

19 Article 21 of the ZBT is not included in the Annex (see Part [7](c) of the Annex)

20 In theory the NBP could also be changed from English to NY law but the experience of market participants to date has been an almost unanimous choice to keep the NBP Transactions and NBP Options under English law even if the governing law of the overall Isda is NY law.

21 For example, under Belgian law Article 13.1.1 (Insolvency) of the ZBT the appointment of a receiver cannot be used as grounds to close-out which is the opposite of the position under the English/NY law Isda.

22 This includes capturing the events that presage insolvency including when a company itself seeks the appointment of an administrator, or a written admission of insolvency.

23 The authors would recommend both the 1992 Guide and the 2002 Isda User's Guide should more detailed explanations be sought.

24 We would note, however, that in the case of the presentation of an insolvency petition by a third party creditor Isda provides for longer grace periods. This may be desirable in certain jurisdictions such as England as a safeguard against frivolous or vexatious litigation.

25 ZBT measures time in Working Days

26 The definition of “Affected Transaction” under Section 14 of the Isda states that all Transactions are to be deemed Affected Transactions except in certain enumerated circumstances. Breach of the NBP/ZBT Terms is not one of those circumstances.

27 Users should note that this issue is not unique to Isda, and may crop up in cross product master netting agreements.

28 If electing to make a breach of the NBP/ZBT operational representations an EoD, parties might consider introducing a grace period following notice, to avoid triggering the EoD in the case of an administrative failure to renew a licence or membership.

29 Buchheit states “[…] it is a brave banker who will rely exclusively on the MAC clause as the basis for accelerating a credit. Most commentators agree that in the absence of some other objective event of default, the change affecting the borrower would have to be “cataclysmic” before a lender could be certain that the materiality test was satisfied” (1994 IFLR 31). This comment is, in our view, also true of the energy sector and the TXU Europe experience showed that there is a real risk that, in some circumstances, an incorrect invocation of a MAC clause to suspend or terminate a trading relationship may result in the threat of litigation.

30 One example of disruption fallbacks is found under Article 7.4 of the Commodity Definitions. Parties who have the Commodity Definitions incorporated into their Isdas need to be careful to avoid incorporating such events indirectly into the Annex. If, they are incorporated, a hierarchy of applicability should be introduced.

31 Section 5(b)(ii) of the 1992 Isda, Section 5(b)(iii) of the 2002 Isda

32 Section 5(b)(iii) of the 1992 Isda; Section 5(b)(iv) of the 2002 Isda

33 For example, Climate Change Levy in the UK.

34 In the case of the ZBT this refinement might be extended to cover any repealing of the present VAT warehouse status.

35 Parts [6 and 7](e) of the Annex refer only to NBP/ZBT Transactions and not to options.

36 Parts [6 and 7](e) of the Annex allow the user to keep the original valuation methodologies.

37 Invoiced amounts are still due under Clause 6 of the NBP, however, such amounts cannot be netted or set-off against the sum calculated under Clause 10.5 of the NBP.

38 Marc Polonsky, [1998] O.G.L.T.R. Issue 4, in “Short-Term Flat NBP Trading Terms and Conditions” argues that another reason for these prohibitions was the desire to have a simple cost calculation method that excluded as many bases for dispute as possible. This methodology may not be appropriate now where parties often have financial hedges to physical positions and the cost of this protection should be taken into account.

Agnes Bizet is a lawyer at Goldman Sachs International. Kevin Wulwik is a lawyer at Deutsche Bank, London. The authors would like to acknowledge and thank all those who took time to review and edit this article.

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