Since the rash of energy company bankruptcies following the turn of the century, the energy industry has been relatively unaffected by major business failures. The SemGroup bankruptcy roiled oil markets in 2008, Lehman Brothers had some business units in the energy sphere, and ASARCO recently completed a high-profile bankruptcy.

Rumors suggested that BP might be forced into bankruptcy shortly after last year’s oil spill in the Gulf of Mexico, and more recently, Dynegy has been the sub­ject of similar rumors. In general, though, energy companies have managed to steer clear of bankruptcy courts in recent years. With uncertainty concerning future economic prospects and interest rates, the time may be right for energy companies to review their plans for a major counterparty bankruptcy.

Long Before Bankruptcy 

Months before a counterparty’s bankruptcy case is contemplated, an energy firm can protect itself by including the proper language in its contracts. The ideal contractual provisions will vary depending on circumstances, but some principles will generally apply.

First, the agreement should include a wide variety of events of default, in add­ition to bankruptcy defaults. This po­tentially allows for earlier termination as the counterparty slides toward bankruptcy. Second, upon a counterparty’s default, the contract should allow for termination of the agreement and un­derlying transactions. Third, requiring segregation of collateral can be helpful – but potentially expensive. Alter­na­tive­ly, the parties should require prompt return of collateral if the market fluctuates against the secured party. Fi­nal­ly, broad rights of setoff or cross-affiliate netting are generally desirable.

Right Before Bankruptcy

In the weeks before a bankruptcy, traders should be perceptive to market ru­mors, which may give advance warning to be­gin contingency planning. Once those rumors are in the marketplace, focus should be on posted collateral and the contractual provisions surrounding it. Trading contracts often do not demand the segregation of collateral. As a re­sult, any surplus collateral becomes exposure to the counterparty.

Before the bankruptcy filing, both the debtor and its trading counterparts will likely make their decisions based on the pending bankruptcy. For example, both sides may delay deliveries and payments as long as possible.

A common question is whether to ac­cept payment from a counterparty that is nearing bankruptcy, considering the possibility of a later preference action. Generally, it is preferable to accept such a payment. Many things can happen after the receipt of the transfer to less­en or eliminate the preference liability: the bankruptcy may be averted, records could be lost or destroyed, or a settlement might eventually be reached with the trustee. In the meantime, the creditor has the time value of the money received. In the energy trading world, it is even more desirable to accept such a payment, because the Bankruptcy Code’s safe harbor provisions exempt many transfers under energy trading contracts from the preference statute.

Following Bankruptcy

A flurry of activity usually follows the bankruptcy filing. Traders should ob­tain reports concerning their exposure and status of physical deliveries. In the first days of the case, the following issues will drive much of the activity: a) the in-the-money or out-of-the-money status; b) status of collateral and letters of credit; c) whether guarantors have also filed for bankruptcy; and d) status of physical deliveries.

Traders also should begin evaluating contractual rights. Assuming that they desire to terminate their contracts, they must be certain that an event of default has occurred and that the contracts allow for termination upon a default. If so, the next question is whether the Bankruptcy Code’s safe harbor provisions apply. Those laws guarantee the ability to terminate, liquidate and ac­celerate certain contracts, even though most creditors are prohibited from do­ing so. If the safe harbor provisions apply, the trader may terminate its transactions with the bankrupt counterparty – but it should note that its rights may expire if it does not terminate promptly. If the trader does not qualify for the safe harbor provisions, then the automatic stay will enjoin it from exercising termination and setoff rights.

If an energy company has recently supplied goods to the debtor, it may have additional remedies. State law provides reclamation, which allows a seller of goods to re­claim certain goods that an insolvent customer received on credit. Bank­ruptcy code allows suppliers to assert administrative expense claims – which frequently receive payment in full – for the value of any goods re­ceiv­ed by the debtor within 20 days before bankruptcy filing.

Trading contracts often require market quotations as the methodology for measuring termination damages. In that case, the non-bankrupt party should carefully prepare to obtain that information from brokers. Worksheets with the needed information and scripts for the traders to read when they make calls to the brokers may be helpful. Traders will need to know the number of quotes to obtain, and to request all quotes for the same day, preferably at the same time. They should generally ask for the bid/offer for each transaction, with quotes for the actual volumes. The traders do not need to enter into any transactions based on the quotes they receive. Finally, they should be cautioned to avoid mentioning de­faults or bankruptcy, or accepting indicative quotes.

The weeks surrounding a major bankruptcy can be stressful and chaotic. Because of the scarcity of funds to be distributed to creditors, it is essential that a trader plans carefully and executes its plan. With the right contractual language and the right steps, the trader may be able to minimize its losses – and the stress.

Paul Turner is co-partner-in-charge of Sutherland Asbill & Brennan’s Houston office and a member of the firm’s energy and environmental practice group. Mark Sherrill is counsel in the firm’s energy and environmental practice group in the Washington, D.C., office. For more information, visit www.sutherland.com.