Written by Tim Baron, Shahen Mirakian, Richard Goodman and Chris Calenti (Student-at-Law)
The recent Australian court decision, Enron Australia v. TXU Electricity [2003] NSWSC 1169 (Enron), has serious implications for derivatives market participants. Although Enron is a decision of the New South Wales Supreme Court, it is very likely that the same result would be reached in any of the Canadian common law jurisdictions. Therefore, Canadian market participants should keep Enron in mind when negotiating derivatives contracts.
The dispute in Enron arises from a fact situation that has become, due to recent events, increasingly familiar to market participants. Enron Australia and TXU Electricity (TXU) entered into various electricity swap contracts governed by the 1992 ISDA Master Agreement (the Master Agreement) in which the parties had elected "Market Quotation" and "Second Method" as the measure and method of payment on early termination. In December 2001 Enron commenced voluntary administration proceedings. Under Section 5(vii) of the Master Agreement, Enron Australia’s actions constituted an Event of Default.
At the time of the occurrence of the Event of Default, TXU was out of the money AUS$3.3 million to Enron Australia under the 78 electricity contracts then outstanding. TXU, as the Non-defaulting Party, had the right but not the obligation, under Section 6(a) of the Master Agreement, to designate an Early Termination Date in respect of all of the outstanding transactions. TXU, in order to avoid payment of its obligations to Enron Australia, chose not to designate an Early Termination Date and relied upon the "flawed asset" provision in Section 2(a)(iii) of the Master Agreement to avoid making any ongoing payments.
Section 2(a)(iii) of the Master Agreement states that each obligation to make payment is subject to the condition precedent that no Event of Default with respect to the other party has occurred. The court ruled that the combined effect of Sections 6(a) and 2(a)(iii) was to leave the Master Agreement in place at TXU’s discretion and allow TXU to suspend ongoing payments until the Event of Default had ceased. Since Enron Australia’s insolvency was not an Event of Default which could be remedied, TXU was effectively able to walk away from its obligations to Enron Australia.
By permitting parties who have elected full two-way payments (Second Method) to act as if they had elected limited two-way payments (First Method), the Enron decision will negatively impact the assets available for distribution to creditors of an insolvent firm where the non-defaulting counterparty is out of the money. Although the Enron decision has been appealed, opinion letters on the enforceability of the netting provisions of the Master Agreement should be qualified for the time being.
Since the Office of the Superintendent of Financial Institutions’ (OSFI) Capital Adequacy Requirements dictate that deposit taking institutions (DTIs) who wish to net transactions under bilateral netting need to satisfy OSFI that a legal opinion is available that "in the event of any legal challenge, the relevant courts and authorities would find the exposure to be the net amount" under the appropriate laws and jurisdictions, there is concern about whether DTIs will be able to net transactions documented under the Master Agreement. The impact that this would have on derivatives markets is so severe that the Financial Services Authority of the United Kingdom has asked the Bank of England’s Financial Markets Law Committee to assess the impact of Enron on regulatory capital netting requirements in the United Kingdom. Therefore, parties who use the Master Agreement to transact should evaluate whether to amend their agreements to include provisions designed to prevent conduct similar to TXU’s and ensure that the Second Method is indeed the true method of calculating payments on early termination.
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
© Copyright 2004 McMillan Binch LLP
