Energy Restructuring & Creditors’ Rights

A recent opinion issued by the District Court for the Southern District of New York (the "District Court") may be cause for some alarm among energy traders. In Tractebel Energy Marketing, Inc. v. AEP Power Marketing, Inc., the District Court held that Tractebel Energy Marketing, Inc. ("Tractebel") had breached a long-dated agreement with AEP Power Marketing, Inc. ("AEP") in which AEP claimed to be in the money. In determining the amount of damages due AEP, however, the court refused to allow damages under the contractual termination payment provision, because the twenty-year period of the agreement prevented any reasonable certainty to the calculation of AEP's damages. This decision adds significant uncertainty to an already difficult area – the valuation upon termination of long-term contracts or of contracts in illiquid markets.

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

Within a short time after execution of the Agreement, Tractebel realized that its estimations of the Agreement's profitability had been overly optimistic. By September, 2002, Tractebel had changed its projections from $80 million in the money to $360 million out of the money. Accordingly, Tractebel began various efforts to get out of its obligations under the Agreement. At the same time, AEP, surely realizing its high profit potential under the Agreement, took various steps to increase its leverage over Tractebel.

Tractebel eventually terminated the Agreement and commenced the action in the District Court. Tractebel first asserted that AEP had breached its implied covenant of good faith. The court rejected that assertion, reasoning that AEP had not acted with the level of bad faith required for a material breach. Tractebel also asserted that AEP had breached the express provisions of the Agreement. The court acknowledged that AEP may not have complied with portions of the Agreement in a few instances, but concluded that such breaches did not rise to the level of a material breach of the Agreement by AEP, which would have allowed Tractebel to terminate.

AEP filed counterclaims against Tractebel, alleging that Tractebel had breached the Agreement. AEP asserted that Tractebel breached both by repudiating the Agreement, and by failing to increase the amount of a guaranty and to make certain payments due under the Agreement. Tractebel did not contest the individual assertions of breach by AEP; instead it argued that it had been released from its contractual obligations by virtue of AEP's breaches. Because the court had already determined that AEP did not materially breach the Agreement, Tractebel effectively had no defense to AEP's allegations of breach. The court, therefore, held that Tractebel had breached the Agreement by failing to increase its credit guaranty and to make payments required by the Agreement.

In determining the amount of damages arising out of Tractebel's breach, the court allowed damages in the amount of $123 million relating to past due (pre-termination) amounts that Tractebel had failed to pay. AEP also sought damages based on the termination payment clause contained in the Agreement. After a termination, the Agreement provided for a payment equal to the difference between (i) the payments Tractebel was required to make under the Agreement and (ii) the market value at the time of the termination of the products Tractebel was to purchase.

The District Court first noted that the termination payment essentially was a means of recovering lost profits from the Agreement. It also noted that the law traditionally allows recovery of lost profits only if the party seeking recovery can establish the existence and amount of the damages with reasonable certainty.

The court then discussed the expert testimony presented by both AEP and Tractebel. The court evaluated AEP’s expert to be better qualified to determine the lost profits, but commented that neither expert provided entirely reliable calculations. It noted that over a twenty-year period, a great number of unknowns must be considered in the projections. "With so many unknown variables," the District Court commented, "these experts might have done as well had they consulted tealeaves or a crystal ball." The determination was further hindered by the fact that, as a new enterprise, the Plant had no historical profits to serve as a guide.

Ultimately, the District Court held that the projection of lost profits by any business over a twenty-year period is inherently speculative. In fact, both experts acknowledged that they had no price curve for the necessary period. As a result, the District Court declined to award any damages under the termination payment clause in the Agreement.

On one level, the court’s holding is specific to the facts of the case. The twenty-year term of the Agreement and the absence of historical profits for the Plant were significant factors in the court’s decision. On another level, however, the opinion is more troubling. If the District Court found that forward curves were meaningless for a twenty-year contract, it is conceivable that another court would make a similar finding with regard to a shorter-term agreement – particularly if reliable forward pricing information is unavailable because of the length of the contract or the liquidity of the location. For example, a party may face great difficulty in trying to determine a termination payment with "reasonable certainty" over a seven-year period because there are no transactable quotes. The significance could be profound. If there is to be significant uncertainty around the enforceability of termination payments for longer-term contracts, then energy traders need to reevaluate their contracts and find new ways to allocate risk and price. If the Tractebel case is any indication, the existing contractual measures for addressing risk may be insufficient.

© 2005 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.