TAKE-OR-PAY IN COMMODITY SUPPLY CONTRACTS – LOOKING BEYOND COVID-19

In the previous two notes in this series we assessed first whether COVID-19 constitutes a force majeure event (FM) and secondly the impact of COVID-19 on existing commercial contracts. This third note focuses on a fundamental feature of many long-term commodity supply contracts—namely the take-or-pay structures.^[1]

COVID-19 has forced both buyers and sellers under long-term commodity supply contracts to identify whether their contracts contain take-or-pay obligations that may be difficult for buyers to meet—especially following reductions in demand from buyers’ downstream customers.

Given this, we expect a major focus of negotiations for future supply contracts to be whether FM (and particularly that resulting directly or indirectly from the occurrence of a pandemic such as COVID-19) should relieve the buyer of any take-or-pay obligations thereunder. The answer may seem obvious but in practice, it is far from it.

This note starts with a recap of a ‘typical’ take-or-pay structure. It goes on to examine the spectrum of positions that may exist in relation to FM relief for take-or-pay obligations before assessing how these positions have been tested in the current environment. It concludes by predicting future trends in this respect (and proposing mitigation options where buyers cannot obtain the desired level of FM relief).

Take-or-Pay Structure: An Overview

• Many long-term commodity supply contracts, particularly those entered into in connection with project-financed “greenfield” infrastructure projects, will incorporate a take-or-pay (ToP) structure. Under a ToP structure, the buyer has an obligation (often on a monthly basis with an annual reconciliation process) to either take and pay for a specified quantity of the relevant commodity (the “ToP Quantity”) or pay the seller for any amount of the ToP Quantity not taken by it (other than due to excused non-take, see below).
• A ToP clause differs from a ‘take-and-pay’ clause in that it lets the buyer decide whether or not to take delivery of the commodity. A ToP clause nonetheless still operates largely to the seller’s benefit in that it places quantity risk on the buyer (i.e. by obliging it to pay for an agreed quantity irrespective of the actual demand from the buyer or its downstream customers).
• A seller may require a ToP structure for many different reasons. These include: (1) its need to secure a stable revenue stream sufficient to support long-term, limited recourse financing; (2) an absence of a spot market for the commodity in question; (3) an inability to turn down upstream production either at all or efficiently or at least without having knock-on consequences for its associated businesses; and (4) the existence of commercial leverage which lets a seller dictate the terms of the relevant supply contract.
• ToP clauses are seldom absolute in that they may oblige the buyer to take and/or pay for only some but not all of the applicable monthly and annual contract quantity (MCQ and ACQ respectively). Percentages range considerably (e.g. between 70 percent and 95 percent) depending upon the commercial drivers for the ToP structure. Often a slightly lower percentage applies on a monthly basis with a higher percentage applying annually. This affords the buyer an opportunity to potentially catch up before an annual reconciliation if the seller makes additional amounts available to the buyer in subsequent months.
• Further, ToP clauses may afford the buyer additional flexibility, including in the form of: (1) downward quantity nominations (i.e. a right to reduce the applicable contract quantity and therefore the ToP Quantity); (2) caps on the buyer’s annual / overall ToP liability; and (3) a ‘make-up right’ (i.e. a right to take, in subsequent periods, any quantities of the relevant commodity for which the buyer has previously paid but not taken (“Make-up Quantity”)).
• ToP clauses typically excuse the buyer from performance of its ToP obligation in certain circumstances. These circumstances may include: (1) the seller’s failure to make quantities available due to FM or its own default; (2) the seller’s delivery of off-specification quantities which the buyer rejects; and (3) the buyer’s inability to take delivery due to FM.
• Much has been written on whether a ToP obligation constitutes a penalty and is therefore unenforceable under English law. The current test to determine whether a contractual obligation is penal is “whether the impugned provision is a secondary obligation, i.e. a remedy available for a breach of a party’s primary obligation, which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.”^[2]

Strong obiter (judicial commentary) suggests that a ToP obligation is a primary obligation, in which case it cannot constitute a penalty.^[3] Even if an English court, or an arbitrator applying English law, found that a ToP obligation did constitute a secondary obligation, given that under English law deterrence of breach may be a ‘legitimate interest’ in some circumstances, they are unlikely to find that a ToP obligation is ‘out of all proportion’ to the seller’s legitimate interest (e.g. in obtaining a steady revenue stream from the buyer)—and therefore unlikely to find that a ToP obligation is a penalty. This is particularly so where the relevant supply contract was negotiated and freely entered into between parties of comparable bargaining power and with the benefit of legal advice.^[4]

FM Relief From Take-or-Pay Obligation: ‘Typical’ Position

• As discussed above, ToP clauses often excuse the buyer from performance of its ToP obligation in certain circumstances, including FM affecting the seller’s ability to make quantities available or the buyer’s ability to take delivery. This is by no means, however, the golden rule. The position may vary considerably according to the industry sector, the parties’ respective bargaining strength, whether the supply contract supports a project financing and whether the buyer is a private or state-owned entity.

Seller-Friendly Positions

• The most seller-friendly position is one where FM does not relieve the buyer from its ToP obligation at all (a so-called ‘hell or high water’ obligation). This effectively means that the buyer must pay for the ToP Quantity even if the seller cannot make quantities available due to FM. For obvious reasons buyers rarely accept such obligations. If found to constitute secondary obligations, such obligations may also be at risk of constituting unenforceable penalties.
• A more common seller-friendly position is one where the buyer is relieved from its ToP obligation for FM affecting the seller only. This is especially typical of supply contracts entered into between a project company and a government-owned offtaker (buyer) in emerging markets—for example in the power sector where the offtaker is the state utility.
  • The rationale is that while the buyer should not be obliged to pay for the relevant commodity unless the seller makes it available, the state-owned buyer should, particularly in respect of political FM events (over which it may have some influence and against which the seller may not be able to insure on commercially reasonable terms) otherwise bear the risk of FM.
  • Another rationale is that even if FM prevents a buyer from taking delivery of commodities this should not affect its ability to pay for them. For example, it is likely to be difficult to argue that a viral outbreak such as COVID-19 has physically prevented a buyer from paying.

‘Balanced’ Position

• The more commercially balanced position in supply contracts made between private entities of equivalent bargaining strength is one where FM preventing the buyer’s ability to “take” should also excuse the buyer’s obligation to “pay.” The logic here is that the buyer should not be obliged to pay where its inability to take is for reasons beyond its control. Another rationale arises in respect of liquid commodity markets (e.g. that for spot LNG) where the seller has greater flexibility to divert the relevant commodity to third parties.

Scope of FM

• Where the parties agree that FM should relieve the buyer from its ToP obligation the next question is what should and should not constitute FM for these purposes. The typical position (found, for example, in the AIPN Master LNG Sale and Purchase Agreement), is that any change in the market or demand for the relevant commodity will not constitute FM.
• In other words, a buyer should not be liable for quantities of which it cannot take delivery due to genuine FM (e.g. whether the pandemic or mandatory quarantines).
• However, a buyer should not be able to use FM to avoid its liabilities simply because of a more general reduction in downstream/customer demand. To do so would cross over into the territory of an economic hardship clause which is not the intention of a FM clause.
  • One recent example is Chinese LNG buyers who are exposed to a fall in domestic gas demand but have found it difficult to claim FM where they can still take delivery at the relevant LNG import terminals. For example, in February 2020 Shell and Total reportedly rejected a FM notice invoked by China’s CNOOC under their long-term LNG sale and purchase agreements on the basis that the quarantine imposed on CNOOC’s regasification terminals was not yet sufficiently widespread to prevent CNOOC from taking delivery.
  • The issue of whether a buyer should be allowed to claim FM in respect of a pandemic that has not impacted the physical ability of the buyer to take delivery is further discussed in the next section.
• Whether a pandemic such as COVID-19 constitutes FM and therefore relieves a buyer from its ToP obligation will also depend heavily on: (1) the specific contractual language; and (2) the specific circumstances surrounding a party’s performance/non-performance.
  • In particular, a typical prerequisite for a FM claim is a duty on the affected party to mitigate the effects of that FM event. Where, for example, a buyer has multiple facilities to which the commodity could be delivered and the facility to which deliveries were supposed to be made is shut down under quarantine orders, the buyer may be denied FM (and therefore ToP) relief where it fails to at least explore alternative delivery points.

Documentation of FM Relief From ToP Liability

• Where it is agreed that FM should relieve the buyer from its ToP obligation, buyers must take special care when documenting this. English-law governed supply contracts typically carve out the obligation to pay money from the scope of obligations which are relieved by FM (unless the physical act of paying is prevented by FM). Taken alone with the ToP obligation, this carve-out would still require a buyer to pay for any quantity of commodity that it failed to take due to FM. The solution is to provide in the ToP clause that any quantities not taken due to FM will be deducted from the ToP Quantity (therefore reducing the ToP payment obligation).

FM Relief From Take-or-Pay Obligation: What We Are Seeing

• Unsurprisingly, COVID-19 has in a number of cases forced both buyers and sellers to identify whether their contracts include take-or-pay obligations that may be difficult for buyers to meet—especially following often major demand reductions from buyers’ own customers.
• Despite their prevalence in supply contracts, ToP clauses are very seldom tested because sellers often prefer to find win-win solutions. These solutions may include rescheduling deliveries, adjusting ToP obligations, extending the contract term and adjusting prices.
• In the current environment, however, we are seeing some buyers claiming FM in an attempt to avoid ToP liabilities under their supply contracts. These claims are sometimes being made where the COVID-19 pandemic alone has not prevented the buyers’ physical ability to take delivery.
• Most FM clauses link the relief for FM-related events to physical inability to take delivery rather than commercial realities that make the compliance with the ToP liabilities more challenging. Recent cases that we have seen test the scope of the FM relief from the ToP liabilities, particularity where pandemic is listed as FM event in the relevant supply contract. The question becomes whether a pandemic that is specifically listed as a FM event that did not impact the physical ability of the buyer to take delivery but did result in a reduction of product demand allows the buyer to claim relief on the basis of FM.
• In these cases, the affected buyers are instead seeking to minimise their liability because they have suffered economic loss due to a downturn in demand from their own customers rather than because the pandemic has prevented their actual ability to comply with the ToP liabilities.
  • A recent example of where a party claimed FM in respect of the pandemic despite its physical ability to take delivery not being affected arose under a nuclear power contract between EDF and Total. Specifically, in May 2020 a French court found on an interim basis that emergency government measures relating to COVID-19 constituted FM and so Total Direct Energie (as offtaker) could refuse to take delivery of and pay for nuclear power supplied by EDF under its so-called ARENH contract. Total’s decision to invoke FM followed a 15 percent to 20 percent drop in electricity demand (and a similar drop in wholesale prices) following the lockdown imposed by the French Government.^[5]
  • Another example has arisen in South Africa, where Eskom has reportedly issued FM notices to operators of independent wind power plants due to lower electricity demand, despite the list of qualifying FM events in the power purchase agreement being a closed list that does not include a pandemic, related governmental measures or a reduction in demand.^[6]

FM and FM Relief From ToP Obligations: Future Trends

• For supply contracts concluded after the advent of COVID-19 we expect the question of FM relief from ToP obligations to attract even sharper focus.
• Generally, we expect to see greater focus on FM and ToP provisions. Buyers will definitely want to see “pandemics” and “epidemics” that affect demand specifically listed as events capable of constituting FM (rather than rely on catch-all language). Sellers on the other hand will need to consider this carefully and whether they are willing to take such downstream demand risk, which is customarily excluded.
• Depending on which side of the supply chain the party sits, supply contracts that are entered into while the effects of COVID-19 are continuing may see parties clarify that both COVID-19 and the effects of any related governmental restrictions (e.g. curfews and travel restrictions) do not constitute FM. The rationale here would be that the parties have had the opportunity to assess and mitigate such effects prior to contracting.
• We also expect parties to make clear whether market/demand changes should be included or excluded in the definition of FM. We may even see bespoke ToP structures concerning pandemic risk specifically, with different treatment for buyers in these circumstances as compared with other types of FM.\
• Conversely, buyers are likely to seek increased flexibility to help them manage fluctuations in demand from their downstream customers, for example in the form of downward quantity flexibility whereby they can reduce the ToP Quantity. Provided they are comfortable with the FM risk allocation, sellers may be increasingly willing to grant this flexibility.

Mitigation Options Where FM Does Not Relieve ToP Liability

• Where buyers cannot obtain the desired level of FM relief from their ToP obligation then they may also want to mitigate their ToP exposure through one or more of the following:
  • make-up rights that are exercisable over a longer period of time (e.g. several years, as opposed to only the next contract year). Make-up rights help to mitigate the absolute loss to the buyer by effectively converting any ToP payment into a working capital cost between the date of the ToP payment and the date on which the buyer receives the corresponding Make-up Quantity;
  • the ToP liability being measured over a long period of time (e.g. annually rather than monthly (or at least with an annual rebalance to allow catch-up));
  • either: (1) greater flexibility to take quantities in excess of the ACQ in order to ‘catch up’ with prior ToP payments; or (2) a rebate on prior ToP payments where the seller is not flexible in supplying excess quantities;
  • caps on the buyer’s annual and/or overall ToP liability; and
  • a lower ToP Quantity by reference to the applicable contracted quantity (e.g. 50 percent rather than 70-95 percent)—the logic being that the ToP payment is only intended to compensate the seller for its fixed costs, and not also its variable costs (which should be minimal in a shutdown). However, as noted above, this approach may not adequately address sellers’ concerns around storage capacity or their ability to turn down upstream production.
• Buyers can further attempt to mitigate their ToP liability by:
  • passing that liability through to any downstream customers, i.e. if FM does not relieve a buyer from its ToP liability under the lead supply contract, FM should also not relieve a customer from its ToP liability under the downstream supply contract. This will require a close examination and careful drafting of the FM and ToP clauses under the buyer’s downstream supply agreements; and
  • assessing the seller’s ability to mitigate its losses (e.g. by curtailing production or by diverting the commodity to third parties) and possibly even obliging the seller to use its reasonable endeavours to do so.