UK: After Enron - The Effect on UK Trading Agreements

Chris Towner of Herbert Smith’s Corporate Group examines some consequences of Enron’s collapse that have not so far received much publicity, namely the impact this has had on energy trading in the U.K. and in particular the lessons to be drawn with a view to revising provisions commonly contained in trading contracts.

Since Enron Corp filed for Chapter 11 proceedings on 2 December 2001 thousands of column inches have been written analysing the rise and fall of this energy trading behemoth. To set the context of this corporate collapse, three "facts" are worth recalling:

• Enron was the largest ever corporate bankruptcy with assets of $63 billion;

• Enron was ranked seventh in the Fortune 500 list of companies; and

• Enron’s share price declined from over $80 a share to under $1 a share in a little over a year.

The effects of Enron’s demise on the accountancy profession, on the regulation of energy trading and even on political funding have been widely discussed. Fewer comments have been made though on the consequences for Enron’s core business activity: energy trading in the US and in the UK.

At the time of its collapse, Enron was the counterparty to approximately 25% of electricity and gas trades in the England and Wales market. By any standards this was a huge market position. Enron also owned and ran the largest on-line trading platform operating in this market. The fact that Enron Europe’s administration on 29 November 2001 did not cause greater disruption in these markets was due in the main to the scrambled unwinding of positions by counterparties in the days prior to 29 November. This window of opportunity itself only existed because the proposed Dynegy take-over of Enron Corp delayed the insolvency of that company by a vital few weeks. This breathing space allowed Enron’s counterparties to adjust their market positions to take account of the impending insolvency.

Now that the once unthinkable has occurred, the UK market has time to consider what lessons for trading contracts should be learnt from this insolvency. It should be remembered that Enron Direct Limited was only the second licensed supplier (following Independent Energy) operating in the UK electricity markets to become insolvent, since privatisation in 1989. The comments below directly relate to the Grid Trade Master Agreement ("GTMA") and the NBP ’99 terms ("NBP terms"). The same types of issues will arise in relation to EFET agreements, ZBT agreements or ISDA based contracts.

While the administration order granted in respect of Enron’s European subsidiaries, for example, would be an act of insolvency and a termination event under both the GTMA and the NBP terms, the practical experience of Enron counterparties was that they wished to be able to terminate contracts before this time. To avoid this position in the future, parties have begun to focus on other termination triggers, such as a material adverse change ("MAC") clause.

Enron themselves had been instrumental in adapting the standard form MAC clause in the GTMA. Enron would typically replace the standard form clause with a clause relating to the credit ratings of the parties. If the credit rating of the counterparty, or its credit support provider, fell below investment grade this was either an immediate MAC, or, alternatively the counterparty was given a brief grace period to arrange alternative credit support. In the second case, a failure to put in place the required credit support was an MAC. It is important to note here which level of credit rating the parties should select. Typically investment grade ratings were chosen, i.e. BBB- or above on Standard & Poor or Baa3 on Moody’s. However, the role of the credit rating agencies in Enron’s demise has provoked considerable comment. Many market participants thought the agencies were too slow to downgrade Enron Corp, because they were aware of the consequences such a step would have. It is one of the many ironies of Enron’s fall that it was the stricter credit regime that they helped construct which finally pulled them down. The rating agencies have since tightened their approach to "asset light" companies, which in itself has provoked a credit squeeze for some American trading companies.

In drafting this MAC provision, which credit ratings agency should be used is vital, as is also whether a cut below investment grade is required by all credit rating agencies quoted in the contract or only by one of those agencies. Particular attention should be paid to the length of the grace period within which any additional credit support could be put in place, and the level of support required.

A further problem faced by some Enron counterparties was that as at 29 November, the Enron party they had contracted with had not yet filed for Chapter 11 proceedings (and in some cases, neither had its credit support provider). In relation to contracts of this type counterparties were often left without an immediate termination right. In cases such as these, some parties could rely on fallback events of default set out in Netting Agreements with their Enron counterparty. It was possible through the use of a Netting Agreement to insert fallback events of default in relation to all contracts between the relevant counterparties. This could, for example, provide that if the relevant Enron parent company suffered an event of insolvency then all contracts between the parties to the Netting Agreement parties could be closed out, irrespective of whether any event of default under the individual contracts had taken place. The use of Netting Agreements increased in the final months of Enron’s decline, and they are becoming an increasingly common feature of trading relationships entered into since that time.

The question of parent company insolvency raised the issue of whether Chapter 11 proceedings in respect of an American parent of an English subsidiary constituted an act of insolvency under an agreement made under English law. While standard form wording relating to "analogous proceedings in other jurisdictions" may give sufficient comfort, it is advisable at the time the contract is entered into to consider where the relevant parent company is incorporated, and making it explicit that the appropriate insolvency events in that jurisdiction are listed in the contract itself as events of insolvency.

A further development arising from Enron’s insolvency relates to the relationship between counterparties and other companies in their group. There have been attempts by Enron to assign profitable transactions from insolvent Enron entities to solvent Enron entities. This leaves a counterparty with a debt to a solvent Enron entity and a claim against an insolvent Enron New partners within the energy group entity. While Enron’s ability to carry out this kind of procedure may be open to challenge, an easier way to address this difficulty is through the assignment provisions in the trading contracts themselves. Prior to Enron’s demise, it was common for assignment to affiliates to it to be possible without the counterparty’s consent. Following Enron’s collapse, companies are closing this potential loophole. There appear to be two options developing, first to have an outright prohibition on any assignment without consent. The second option is to state clearly that any consent is subject to existing netting rights under the trading contract itself. There is also a question as to whether a party may only assign all of its transactions under a GTMA, for example, or whether a party is able to cherry pick the contracts which they assign. Under the NBP terms the right to assign each Transaction (whether profitable or not) is clear.

Assignments of rights in breach of the terms of the contract would in itself be a material event of default. If that type of event is not cured in the relevant grace period, then a right to terminate the contract normally arises. The length of grace periods is another factor that has received attention since Enron’s insolvency. Grace periods had already been looked into in the American market in the light of the Californian experience with electricity supply, and in particular the insolvency of the power suppliers in that state. Those cases focussed on grace periods for non-payment, but similarly truncated timescales have been put in place in relation to material events of default. These can now be as short as two banking days.

One of the fundamental themes running through these changes is credit. It was the downgrade made by credit rating agencies that forced Enron companies to put up extra credit support that finally broke Enron. Since November several other traders have faced credit squeezes as ratings agencies and banks have become far more cautious in their approach to companies in this market. Calpine and Dynergy have sought extra credit lines to boost their liquidity. Aquila, on the other hand, reacted by purchasing physical assets from Cogentrix and immediately saw its stock price fall 30% owing to market fears regarding Aquila’s increased debt.

Credit and the terms of credit under trading contracts are fundamental to the continued operation of these markets. In these circumstances it is no surprise that the executive vice-president of Duke Energy is calling for standardised credit terms in US trading contracts. In the UK at least the market seems to be getting there itself.

© Herbert Smith 2002

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