The drastic and continuing reduction in worldwide commodity demand has left the oil and gas industry in disarray. As a result, upstream producers have laid down rigs, shut-in wells and have significantly decreased production, thereby raising credit concerns across the industry. In response to requests from Texas Senator Ted Cruz and a push by small and mid-sized oil producers, and in order to avoid, or at least minimize, the possible bankruptcies arising from the demand issues facing the industry, the Federal Reserve on April 30, 2020 announced changes to the Main Street Lending Program. These changes pave the way for the oil and gas industry to obtain government financing to deal with the tight credit market caused by the deterioration in general economic conditions following the COVID-19 pandemic.
Due to the integration of the oil and gas supply chain, upstream producers’ decisions to cut production and shut-in wells have cascading effects for infrastructure projects and midstream companies. Although midstream operators do not generally bear direct commodity risk, such entities: (i) rely on the credit worthiness of their counterparties, (ii) expect to earn a return on capital in connection with their assets (e.g., pipelines, processing plants, etc.) that is directly correlated to the volume of product flows through such assets, and (iii) often have long-term, firm delivery/sale obligations downstream of their assets. Consequently, despite the fact that midstream services contracts are for the most part structured to avoid direct commodity pricing exposure, midstream companies will nonetheless tend to experience significant revenue volatility as prices and the demand for oil and natural gas continue to remain low. This connection between the upstream and midstream industry segments is evident in the movements of equity share prices of publicly traded midstream companies – although the midstream business model is based on long-term, committed through-put agreements versus the need to produce and sell hydrocarbons for a profit, upstream and midstream equities both tend to rise and fall lockstep with the price of oil. As upstream and midstream companies face depressed stock prices and mounting credit challenges in the current environment, one contractual consideration which will loom increasingly large in the coming months is adequate assurance or credit enhancement. This update will provide an overview of a typical adequate assurance provision in a midstream services contract and discuss whether such a provision provides a meaningful remedy to a party seeking to assert its rights to receive adequate assurance.
Performance Assurance Provision
Although not exclusively limited to midstream contracts, the adequate assurance provision is a common feature of midstream services contracts, and although it is often drafted as a bilateral obligation, the practical effect is to provide the midstream service provider with assurance that payments required under a contract will continue to be made if the counterparty experiences financial distress. An adequate assurance provision is often highly negotiated by the parties, primarily because there is usually no objective criteria to determine what is meant by “financial distress.” A typical assurance provision contained in a hydrocarbon storage lease provides:
If during the term of this Lease reasonable grounds for insecurity [italics added] arise with respect to the performance of Lessee’s (or, if applicable, Lessee’s guarantor) obligations pursuant to this Lease, Lessor may demand, in writing, adequate assurance of due performance, in the form of either a letter of credit or other security deemed reasonable by Lessor, in its sole discretion, in each case, in the form, amount, for a term and from an entity reasonably acceptable to Lessor. Lessor may suspend performance under this Lease if such adequate assurance is not received within three days of such written request.
What are Reasonable Grounds for Insecurity?
In the example provided above there is no definition of “reasonable grounds for insecurity” and begs the question as to what that term might mean. Perhaps the most obvious reason a midstream operator would have reasonable grounds for insecurity with respect to its counter-party’s ability to continue performing under the contract is the counterparty’s failure to make timely payments. Indeed, an adequate assurance provision will often explicitly provide that “reasonable grounds for insecurity” means, among other things, that the counterparty has failed to meet its payment obligations under the contract. The potential issue for the midstream operator in this case is that large throughput volumes of product flow under a midstream services contract each month and such contracts are typically drafted so that invoices for product delivered in a given month are only issued in the following month. Payment is generally due 30 days after the invoice date and is not considered past due for up to another 30 days thereafter. Thus, the midstream operator will likely be exposed to a large unpaid payment accrual before having the right to request credit assurance under the contract.
Quite apart from specific failures to pay amounts due, some midstream services contracts define “reasonable grounds for insecurity” to include the bankruptcy or insolvency of a party. However, “bankruptcy” and “insolvency”, if not specifically defined in the agreement, are likewise subject to wide interpretation. While the U.S. Bankruptcy Code provides statutory guidance as to the requirements of bankruptcy and insolvency, due to the time it typically takes to prepare for and commence an insolvency proceeding, a creditor would similarly be exposed to a large unpaid payment accrual. Moreover, upon a counter-party’s filing of a petition under the U.S. Bankruptcy Code, a creditor’s ability to invoke a remedy under its contract with such counter-party will be subject to the bankruptcy court’s automatic stay provision.1
Another approach to defining “reasonable insecurity” commonly seen in midstream services contracts is to establish a credit benchmark in the contract, a departure from which would constitute prima facie grounds for requesting adequate assurance. For example, it is reasonable for the Lessor to be insecure in the Lessee’s ability to perform under the contract if the Lessee’s senior unsecured debt or equivalent is downgraded by Moody’s Investor Service to or below a Ba1 rating or by Standard & Poor’s to or below a BB+ rating. Although this approach provides an objective test for determining insecurity, and may function as an effective early trigger to request adequate assurance before a payment default actually occurs or before the onset of bankruptcy; it is, as a practical matter, of limited utility in a market comprised of many entities which do not possess a debt or corporate credit rating, or whose ratings are barely above junk status.
Finally, although some midstream services contracts tie the “reasonable grounds for insecurity” standard to an event that constitutes a basis for requesting adequate assurance of performance under Section 2-609 of the Uniform Commercial Code (Sale of Goods), limited objective criteria is found in the actual statutory provision, which provides:
§2-609 Right to Adequate Assurance of Performance.
(1) A contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may, if commercially reasonable, suspend any performance for which he has not already received the agreed return.
(2) Between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards.
(3) Acceptance of any improper delivery or payment does not prejudice the aggrieved party's right to demand adequate assurance of future performance.
(4) After receipt of a justified demand failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract.
In Texas, determining whether a party has “reasonable grounds for insecurity” depends on “all the circumstances of the particular case.”2 Such “reasonable grounds for insecurity” typically do not include any risks assumed by the parties when they entered the contract, but rather “reasonable grounds” will be based on those specific facts that arose after the execution of the contract.3
Assuming Reasonable Grounds for Insecurity Exist – Can/Should the Assurances Provision be Invoked?
The starting point for this discussion is that any adequate assurances provision is only useful to the requesting party to the extent of the providing party’s ability to furnish the requested form(s) of adequate assurance. To the extent specified in a contract, the most common forms of adequate assurance are: (i) a guaranty from a credit worthy person or entity (usually a parent entity), (ii) a letter of credit in form and substance satisfactory to the requesting party and issued by an entity meeting contractually defined minimum financial standards, or (iii) a cash prepayment. Note that the matter of which party gets to select the form of adequate assurance to be provided is generally a negotiated point.
A guaranty that a party’s obligations will be paid or performed is often not a viable option because a creditworthy guarantor may not exist, or may not otherwise be willing to provide, or is prohibited from providing (whether pursuant to organizational governance prohibitions or due to debt facility restrictions), a guaranty. If the parties do desire a guaranty, the form of the guaranty and identity of the guarantor is usually agreed beforehand. In some instances, a party may request that a guaranty be put in place and maintained as a continuing condition of its performance under the contract.
Although the provision of a letter of credit may be an option if the providing party has an existing credit facility with a letter of credit sub facility in place at the time the credit assurance is requested, it is likewise often not a viable option. As is the case with a standard credit facility, a letter of credit requires underwriting diligence by the issuer and usually requires collateral support in the full face amount of the letter of credit. Not only does the underwriting process take time, unless collateral under an existing credit facility is in place and provides credit support for repayment obligations if the letter of credit is drawn, the issuer will likely require 100% cash collateralization of the letter of credit. If a party is required to provide 100% cash collateral, it probably makes more sense to avoid the complexities of issuing a letter of credit and instead, provide the third form of credit assurance: a cash prepayment for future services. One further complicating factor with a letter of credit is the credit assurance language is often silent regarding what happens if the letter of credit is drawn by the insecure party to satisfy a payment deficiency. If, for example, the letter of credit does not provide for replenishment in the event of a draw, then the requesting party may, in the event of multiple draws, be left with a letter of credit of steadily diminishing value.
Although a cash prepayment is the most common form of credit support often provided, the amount of the advance is not always specified in the contract. As noted in the sample provision above, often the provision will state the payment shall be in an amount acceptable to the insecure party. Because this raises additional subjectivity that may lead to prolonged disagreement among the parties, the better practice is to include a predetermined amount such as the aggregate amount due under the contract for the prior three months. As is the case with a letter of credit, if a prepayment is requested, the providing party should also be required to make further advance payments to continuously maintain the required prepayment balance during the period of insecurity. Assuming a cash prepayment is the only likely form of credit support available to a midstream provider who is concerned with a counterparty’s ability to satisfy its financial obligations, if the counterparty is in financial distress, it is unlikely sufficient cash exists to make a material prepayment for services to be performed in the future (and for which the counterparty has not yet realized revenue), and even if the counterparty does have sufficient cash but is teetering on the edge of solvency, a large prepayment may push it into insolvency, in which case there will likely be no continued performance under the contract. Therefore, the midstream provider is faced with the practical consideration of conditioning its continued performance upon receipt of credit assurance or continuing to perform without receiving such assurance in anticipation that maintaining the counterparty’s liquidity will permit the counter-party to maintain business continuity and, in turn, permit the provider to realize a continued payment stream for services performed under the contract. Often, the most appropriate course is somewhere in the middle insofar as the midstream provider requires credit assurance to minimize its risk exposure, but in an amount less than the full amount that is required under the contract.
In the coming months, the energy sector will need to confront two challenges simultaneously: on the one hand, managing depressed commodity prices coupled with lower demand, and managing counterparty credit and debt obligations on the other. While an adequate assurances provision provides a creditor party with a panoply of options in the event that its counterparty becomes financially distressed, because (i) many such provisions do not adequately define the basis for triggering the right to request adequate assurance; (ii) as a practical matter, a counterparty’s ability to actually provide the requested adequate assurance may be limited; and (iii) compliance with a request for adequate assurance may have negative unintended effects, the exercise of those options is far from a straightforward matter.
1 11 U.S. Code §362.