Most LNG deals are concluded via an email deal sheet (Deal Sheet) between traders. The Deal Sheet will usually contain an incomplete set of generic trade terms similar to those found in an LNG confirmation notice (CN). They normally contain a crucial ‘subject to‘ provision which, depending on how it is drafted, has the potential of turning a ‘firm’ deal into a free option to walk away from the trade.
This Client Alert reviews the problematic provision, provides context as to why it is used by traders and outlines options for best practice for future deal sheets.
‘Subject to’ provisions in Deal Sheets
Most Deal Sheets will contain a provision similar to the following:
“deal done subject to execution of the confirmation notice“
When included and depending on the wording used, this provision can prove fatal to the deal ever becoming binding on the parties. The wording above has the effect of converting a supposed firm deal into a free option to walk away if, for example, the market moves against one of the parties. In extremis, a deal is sometimes done subject to the parties executing a CN and an MSPA – a difficult hurdle to overcome.
To understand why ‘subject to‘ language is included in Deal Sheets, it is first necessary to review the trade execution provisions contained in a typical LNG Master Sale and Purchase Agreement (MSPA).
Master Sale and Purchase Agreement Execution Clauses
Most, if not all, MSPAs contain a clause which expressly states that a deal is only legally binding when a CN is executed by both parties. For example, in the EFET standard form DES LNG contract, the following clause is included:
From time to time the Parties may, but are not obliged to, enter into a Transaction by executing a Confirmation Notice substantially in the form set forth in Exhibit A hereto.
This is fairly typical language found in many MSPAs. It means that the parties are not obliged to ever enter into an LNG trade by virtue of executing the MSPA, but that when they do so, the trade must be documented by the parties by executing a CN.
The rationale for this practice is three-fold:
- LNG trades are complex, detailed and need to link into the MSPA framework of clauses to make sense.
- prior to the emergence of the spot market, LNG trades where not entered into infrequently and with long tenors, therefore there was plenty of time for CNs to be drafted, negotiated and executed in advance of delivery.
- traditionally, with the small number of players in the market you had reputational certainty of counterparty performance.
There are many examples of alternative trade execution approaches which can be found in standard energy trading documentation.
For example, the LNG market takes a very different approach to the European natural gas and power trading market. Under the standard form EFET Gas General Agreement (EFET Agreement) the trade execution clause is as follows:
Unless otherwise agreed between the Parties, Individual Contracts may be concluded in any form of communication (whether orally or otherwise) and shall be legally binding and enforceable from the time the terms of such Individual Contract are concluded.
There is a clear difference between the two approaches, with the LNG trade being considered binding upon CN execution and an EFET trade considered binding when it is actually entered into (by phone or otherwise).
The EFET Agreement also contains an election to state that from the date of execution, all future trades entered into between the parties in relation to a particular commodity (in this case, natural gas) are automatically considered to be subject to the EFET General Agreement terms unless expressly excluded. MSPAs do not contain similar provisions.
Increasingly, market participants are more willing to walk away from deals considered firm by their counterparty, relying on inadequately drafted “subject to” provisions in the Deal Sheet as the basis for doing so. Whilst potentially legally permitted, the reputational damage inherent in doing so would historically have outweighed the commercial benefits in the long run. This is no longer the case given the increasingly large number of market participants and where cargo availability trumps reputational knocks.
Clearly, the impact of a counterparty reneging on a deal thought to be firm is potentially catastrophic. Where a cargo has been on-sold and a CN has been executed for that onward sale, if the counterparty in the original deal walked away, using the ‘subject to‘ language as the basis, there would arguably be no legal right of action against that original party. The trader stuck in the middle will at best be left short a cargo that must be covered in the spot market at an unknown price or from its own wider portfolio, or at worst be liable for non-delivery to the onward party.
Risks around using ‘subject to‘ language can be mitigated in a number of ways. Assuming the MSPA is already in place, we provide a tool box of approaches below which may form a useful base for a deal execution policy.
Don’t commit to legally firm onward trades until your initial trade is legally firm
A fairly obvious but overlooked precaution is to never agree to a legally binding onward position unless your original trade is also legally binding. This is less of an issue if a trader’s portfolio is large enough, or the spot market is buoyant enough, to provide access to substitute cargos which can be utilised in the event of a walkaway on the original trade.
Draft the CN during commercial negotiations and sign immediately upon trade conclusion
A safe and prudent way to deal with this situation is to draft a comprehensive CN in tandem with the commercial negotiations, updating final pricing information when commercial terms are agreed. The CN should then be signed by both parties immediately and exchanged on conclusion of the deal. The time between conclusion and execution of the CN should then only be a matter of minutes or hours.
Although this belt and braces approach is legally the most sound, without significant legal resources to hand, it may be impractical to draft CNs in this way for all of the deals an established LNG desk is negotiating at any one time. Deals come and go regularly and the very nature of the spot market means that a lot of internal resources will be wasted in continually drafting CNs which are never used.
Draft and sign the CN in advance and include an option clause
We have also seen scenarios where CNs are executed in advance and which contain a short term option clause. The clause will specify a time and date by which one party must exercise the option, only upon exercise of the option will the deal become legally binding.
This approach may not be desirable from a commercial perspective as additional costs may be incurred in order to build in the optionality. In practice, this approach likely to change the commercial nature of the deal too much to be a useful solution.
Develop a clause which reflects true market practice and include it in the MSPA
Borrowing from the EFET Agreement, it is possible to amend standard form MSPAs such that a deal is considered done once it is agreed (no matter the method used for reaching agreement). Including a provision similar to that in the EFET Agreement which deems all future LNG trades between the parties as a trade under the MSPA is also advisable if this option is taken.
In our experience although parties are usually receptive to the issue and the solution, most will not agree to amend MSPA terms to include such a clause as they consider physical CN execution as being the ‘market standard’. They fear that deviating from this standard in only one or two MSPAs would cause too much back-to-back risk.
Include comprehensive ‘subject to‘ language in all Deal Sheets
Given the difficulties described above, it is likely necessary that ‘subject to‘ language will continued to be used in Deal Sheets. It is therefore essential that any ‘subject to‘ wording used is watertight – a badly drafted clause which, for example, contains no reasonable endeavours obligation or deadline for execution could come back to bite.
As a general rule, good ‘subject to‘ language should include the following:
- mutually acceptability wording; the CN must be negotiated to be mutually acceptable to both parties incorporating the terms contained in the Deal Sheet. Provisions allowing only one party to determine acceptability should be avoided.
- a deadline;the provision should clearly state a time, timezone and date by which the CN should be executed. If no deadline is stated, then English law implies that the CN must be executed within a reasonable time.
- deadline extension rules; consider including a provision to allow the parties to extend the deadline by mutual consent so as to avoid the deal lapsing unintentionally.
- details on what happens if the CN is not executed; the provision should be clear as to what happens if the CN is not executed by the deadline. For example a usual consequence is that the deal is considered null and void or lapses.
- a reasonable endeavours obligation; it is essential that the provision states whether or not a party is obliged to procure the execution of the CN, and if they are, how extensive that obligation is. Usually parties are required to use reasonable endeavours to execute the CN by the deadline. Occasionally a party may seek to apply a best endeavours obligation though this should generally be avoided.
For completeness, best practice should also include documenting by email when the ‘subject to‘ conditions have been met.
An extra issue to consider…
Where a trader wishes to enter into a deal ‘subject to‘ execution of the CN and an MSPA, additional care should be taken before considering the deal as legally firm.
Compounding the CN execution process, MSPAs are long documents, very complex and usually require a lot of negotiation between legal teams. The chance of failing to reach agreement on the MSPA terms in a tight timeframe are high.
A common commercial solution to the MSPA issue is to agree to use one party’s unamended standard form MSPA as a one off solution to document the deal. If this approach is taken, care should be taken to ensure that the MSPA is terminated at the appropriate time after all obligations under the deal have been satisfied.
Until a trade is legally firm, meaning both the MSPA and CN for that trade is executed, extreme care and consideration should be taken before committing to onwards trades of that cargo. We have outlined some measures which can be implemented to mitigate this issue however as the market develops further and prices become more volatile, we expect there to be an increase in walkaways across the board for a variety of reasons.
Ensure that your wording watertight, that you know when the deal is legally binding and what your backup is if a counterpart reneges. Never be complacent and be aware that any counterparty may walk away from a deal if the market suddenly moves against them.
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.