Destination restrictions, profit share arrangements and take or pay obligations are a common feature in LNG contracts. However, if your buyer is based in Japan, the inclusion of any of the above clauses in an FOB sale contract may now be illegal and contrary to the Japanese Antimonopoly Act.
The Japan Fair Trade Commission (JFTC), which is the competition regulator in Japan, published a report on 28 June 2017 into restrictive clauses found in LNG sale and purchase contracts.
In summary, the JFTC concluded that:
- Destination restrictions in FOB LNG contracts likely violate Japanese antitrust law; those found in DES LNG contracts to define a delivery point are however permissible (so long as Sellers act reasonably and fairly in considering any diversion request).
- A clause requiring profit sharing upon a diversion in an FOB LNG contract is considered a violation of Japanese antitrust law. This is not the case for DES LNG contracts, unless the clause is unbalanced and too favourable to the seller.
- Take or Pay clauses are considered reasonable and prima faciedo not violate Japanese antitrust law, but they have the potential to so in certain circumstances.
Future enforcement risk by the JFTC is likely to be high given Japan’s reliance on LNG for power generation and interest in increasing competition and therefore drive down prices.
The JFTC has recognised that there may already be many existing contracts which contain destination clauses. As such, they do not require market participants to renegotiate their current contracts. They do require parties to adhere to the new rules when a contract is revised or a new contract is entered into.
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Destination Restriction Clauses
Japan is still reeling from the Fukushima nuclear disaster and continues to be the hot destination for LNG sales. Security of supply and price reduction are therefore key policy objectives for the Japanese government.
Buyers in Japan buy LNG from domestic and international suppliers on both a long term basis and on the burgeoning spot market.
As you may expect, destination restrictions restrict where the buyer can unload its LNG. The rationale for such restrictions are routed in traditional long term supply agreements whereby different geographic regions around the world had unique pricing structures. A seller did not want its buyers to be able to arbitrage this price differential.
The JFTC considers that destination restrictions are a practical hindrance on Japanese LNG users from reselling LNG to other parties. They consider that such clauses exclude new participants from agreeing long term contracts in the Asian market or spot contracts worldwide. The effect of this is a decrease in competition and an increase in LNG prices. Such clauses are considered to have a “foreclosure effect” and as such violate Japan’s Antimonopoly Act (Unfair Trade Practices: Trading on Restrictive Terms).
Unlike in DES LNG contracts, there is no requirement to include a diversion restriction in an FOB LNG contract as title and risk in the is passed at the loading port. Quite simply, the JFTC considers that:
“destination restrictions [in FOB contracts] prevent buyers from reselling LNG freely and properly, even after [title and risk is passed]. Therefore, under an FOB contract, the restrictions on diversion as well as the provision of destination clauses are not generally considered as reasonable.”
The JFTC considers these clauses to be overly favourable to the seller, have a detrimental impact on fair competition and are unnecessary from a contractual efficacy perspective. Future FOB sales to Japanese buyers should therefore not include destination restrictions.
Under a DES LNG contract, it is necessary to agree an unloading port with the seller (i.e. a destination restriction) as it is the seller’s responsibility to arrange transportation of the LNG to the unloading port. Therefore, all DES contracts which specify an unloading port contain a destination restriction.
In our experience, DES contracts may also specify a range of unloading ports which the buyer or seller (as applicable) must nominate or narrow as the delivery date approaches.
The JFTC concluded that the inclusion of a destination restriction in a long term DES contract “in order to define a delivery point” is not contrary to Japanese antitrust law, this includes clauses which permit a diversion only on seller’s consent or which contain a fairness or reasonableness requirement. Any refusal by the seller of a reasonable diversion request by the buyer (even when this is not specifically permitted under a fixed-term DES contract) is likely to be a violation of the Antimonopoly Act, further any diversion restrictions imposed by a DES seller on the grounds of “operational or contractual” reasons are highly likely to be a violation.
Profit Share Clauses
The JFTC also considered whether profit share clauses which are connected to a diversion of a cargo violate the Antimonopoly Act. These clauses will usually require a party to share any additional profit made by diverting a cargo with the seller. They will sometimes split the profit on a net basis or a gross basis and in different percentage ratios.
The JFTC considers that the inclusion of such clauses in LNG contracts acts as a further restriction on reselling of LNG to other users, thereby potentially stifling competition. Further, where the methods for calculating the profit share are unclear, the distribution ratios are uneven or where the buyer is required to submit confidential information to the seller, then the negative impact of the profit share arrangement on the market increases significantly.
Like with destination restrictions above, the JFTC considers profit share clauses in FOB LNG contracts to “indirectly prevent buyers from reselling freely and properly [and] therefore, in general, such clauses are not considered as reasonable.“
They should therefore be avoided in all future contracts which Japanese buyers.
Inclusion of a profit share clause in a DES LNG contract is reasonable as although there is an indirect restriction on resale, the profit share is considered to be a kind of liquidated damages for contractual variation.
Even in a DES LNG contract however, care should be taken to draft a clause which:
- properly considers the seller’s actual contribution to the resale;
- uses only net profit as the basis for the profit share (and not gross profit); and
- is not overly burdensome on the buyer to disclose profit information of its trading portfolio or cost structure.
Non-compliance of the above may trigger an antitrust violation – even on a DES sale.
Take or Pay Clauses
Finally, the JFTC considered the legality of take or pay (ToP) clauses, however their guidance is somewhat vague.
The JFTC recognises that ToP clauses are necessary and reasonable to guarantee sustainable and full payment from buyers in relation to new LNG facilities coming on board – they are an essential part of the investment and funding criteria. However once such initial loans and financing are paid off, the JFTC considers the rationale for their inclusion as more suspect.
In rather opaque terms, the JFTC states in its report that:
“[…] when a seller’s bargaining position is super to that of a buyer and the seller unilaterally imposes Take of Pay clauses and strict minimum purchase obligations without sufficient negotiation with the buyer even after the seller has already got sufficient return for initial investment, strict minimum purchase obligations as well as providing Take or Pay clauses are likely to be in violation of the Antimonopoly Act (Unfair Trade Practices: Abuse of Superior Bargaining Position).”
The meaning of “sufficient negotiation” and “sufficient return” is ambiguous and unclear. It will be interesting to see how the JTFC develops this position over the coming years.
The JFTC has taken a practical approach to the implementation of the new rules by looking to the future, rather than requiring reopening of any existing arrangements, and has concluded that:
“[…] when LNG sellers conclude a new contract or revise a contract after expiration, LNG sellers […] should not provide competition-restraining clauses nor take business practices which lead to the restrictions of resale and so on. Also, as for the existing contracts before the expiration, LNG sellers, at least, should review competition-restraining business practices which lead to restrictions of resale and so on.”
The JFTC report is a welcome clarification on three tricky LNG clause types. FOB sellers should review its standard operating procedures and ensure traders are aware of these new restrictions in relation to buyers based in Japan.
Interestingly, the JFTC express stated that it expects Japanese buyers to ensure savings made in procurement costs of LNG (following increased market competition) are reflected in electricity rates and/or city gas rates for the benefit of Japanese consumers. This strikes as quite interventionist and could be an indication of future reviews by the JFTC in years to come.
Enforcement risk going forwards is high and the JFTC has expressly stated that it will continue to monitor the LNG market and take “strict actions against any violations of the Antimonopoly Act.” Time will tell on how active the JFTC will be, but with Japan’s continuing reliance on LNG imports for power generation, LNG will remain high on the political agenda.
The full report can be downloaded from the JFTC website here.
Since publication of this Client Alert, both Jera and Tokyo Gas have announced that will both only sign supply deals with no destination clauses. It will be interesting to see the impact this will have on the market and whether the JFTC’s objectives will be met.
Please call Nic Horsfield, Partner on +65 8792 9080 or email him to discuss anything contained in this article or our LNG practice and services in more detail.
This client alert does not constitute nor is it intended to be legal advice.