The Japan Fair Trade Commission (the “JFTC”) recently undertook a survey to review destination restriction clauses in contracts for the sale and purchase of liquefied natural gas (“LNG”). Included at the end of the JFTC’s reported findings is a somewhat critical commentary on the “take-or-pay” contract structure that has long been used in the LNG industry.^[1]   By way of background, under a traditional take-or-pay contract, the buyer must pay the full contract sales price for all of the contracted quantity for each measurement period (typically on an annual basis), including any quantities it does not actually take during the measurement period. In exchange, the buyer earns the right to later receive any quantities that it previously paid for but did not take during the applicable measurement period.

As the JFTC acknowledges, the take-or-pay contract structure was originally designed to provide the seller with a guaranteed revenue stream that in many cases is necessary to support the large initial investment and financing for an LNG export project. However, the JFTC questions the need for, and the enforceability under Japan’s Antimonopoly Act of, take-or-pay obligations that apply after the seller has repaid its debt financing and received a full return on its initial investment. Most LNG industry observers know that any suggestions or commentary coming from the Japanese government, even those not having the force of law, tend to at least influence the Japanese buyers’ contracting demands and methods.  In this case, it may well be the case that JFTC’s criticisms of the traditional take-or-pay contract structure was actually driven by the Japanese buyers’ prior comments to the JFTC during the survey. In any case, the JFTC’s comments likely will lead to a more vigorous attempt by Japanese buyers to press LNG sellers for contracting structures that deviate from the traditional take-or-pay contract structure.

In this article, we examine two main alternatives to a take-or-pay contract structure, including a discussion covering some pros and cons of each structure as compared to the traditional take-or-pay contract structure.

Summary of Key Terms under the Take-or-Pay Contract Structure

Before we introduce and analyze the alternative contract structures, we will summarize the key components of a traditional take-or-pay contract structure. In very simple terms, the take-or-pay obligation is an obligation by the buyer to either take and pay for, or pay for even if not taken, a certain quantity of LNG in a defined measurement period (typically annually, and defined as the “annual contract quantity” or “ACQ”) within the overall contract term.^[2] As the JFTC noted in its report, the take-or-pay contract structure ensures that the buyer bears the full quantity risk because it must pay for a certain quantity of LNG each measurement period, regardless of the actual demand on the buyer side during that same period. This risk allocation provides the seller with the certainty of regular project revenues and, in general, a predictable cash-flow stream that is a prerequisite for the type of multi-billion dollar project financings that are usually required by greenfield LNG export projects.

Because the buyer must nonetheless pay the full contract price for quantities that it fails to take during the applicable measurement period, upon making such payment (commonly known as the “take-or-pay payment”), the buyer usually becomes entitled to what is called a “make-up” right, namely, a right to take at a future date the quantity of LNG for which it has made the take-or-pay payment. As a matter of U.S. law, a provision under which the buyer may elect to pay for LNG not taken during the applicable measurement period in exchange for future make-up rights is considered an alternative to the obligation to both receive and pay for LNG during the applicable measurement period. Thus, under U.S. law a take-or-pay payment is not considered to be a damages payment that might otherwise be subject to attack as an unenforceable penalty due to its lack of relationship to the seller’s actual loss or harm when the buyer fails to take scheduled quantities of LNG.^[3] It is likewise clear that a take-or-pay contract structure is enforceable under English contract law, although the rationale the English Courts use to defend this position is somewhat different.^[4]

Typically, a buyer’s right to receive quantities of LNG pursuant to a make-up right may be exercised for no additional payment at all (the take-or-pay payment is essentially deemed to be payment in full for the corresponding make-up quantities), or it may require an additional payment (either by buyer or seller, as the case may be) for the differential between (i) the contract price prevailing at the time of receiving the make-up quantities and (ii) the contract price used to calculate the take-or-pay payment. Further, the buyer’s make-up right usually is not absolute and is often subject to certain conditions, such as the seller only being obliged to use reasonable efforts to make available the make-up quantities given the seller’s available production capacity. In contracts in which the seller is required to deliver LNG at the buyer’s nominated receiving facilities, the right of the buyer to receive make-up LNG may further be subject to the seller’s available shipping capacity. These conditions are intended to protect the seller since any make-up quantities would need be scheduled in addition to its then-existing delivery obligations to all of its various buyers, including for ACQs under the seller’s other take-or-pay sales contracts.

Traditional take-or-pay contract structures in the LNG industry have also been accompanied by certain annual quantity flexibility rights exercisable by the buyer. Such flexibility rights typically include: (a) certain permitted downward (and sometime upward) quantity adjustments that may be elected by the buyer at the time it is scheduling deliveries for the upcoming measurement period, (b) the buyer’s right to request the delivery of any make-up quantities to which it has become entitled by virtue of making a prior take-or-pay payment, and (c) in many cases, the buyer’s right to request the delivery of certain quantities corresponding to amounts that it had exercised downward quantity flexibility rights in prior measurement periods. In such manner, the total take-or-pay obligation for which the buyer becomes obligated each measurement period is determined after taking into account any and all such flexibilities exercised by the buyer, as well as any permissible quantity flexibility rights exercised by the seller, in each case for the applicable measurement period for which the delivery schedule is being established.

Importantly for the buyer, its obligation to make a take-or-pay payment typically only occurs at the end of each applicable measurement period. As such, the a buyer’s failure to take and receive any particular scheduled LNG cargo during the measurement period will not result in any immediate payment obligation or liability at the time of such failure, nor will it necessarily result in a take-or-pay payment at the end of the applicable measurement period as long as the buyer manages to schedule sufficient replacement LNG (by way of the exercise of upward quantity flexibility rights or otherwise) before the expiry of the applicable measurement period. The downside to the buyer is that it can potentially, through incremental failures to receive scheduled quantities of LNG, accumulate a very large take-or-pay obligation over the course of the measurement period that could be very difficult for the buyer to pay in a single lump-sum payment or pass on to the buyer’s end-customer, such as a power plant operator.

Alternative 1: Take-and-Pay Contract Structure

One of the two alternative contract structures common in the LNG industry is a take-and-pay contract structure, which has recently emerged as the typical structure for many of today’s spot and portfolio LNG sales.^[5] Under a take-and-pay contract structure, the buyer must take and pay for the contracted quantity, and any failure by the buyer to do so will result in an immediate damages payment obligation that accrues at the time of such failure. The key differences between a take-and-pay contract structure and a take-or-pay contract structure are thus the timing of when payments must be made to the seller and the seller’s specific remedy for quantities that the buyer fails to take.

As for the latter difference, there are two common remedy alternatives that may be applied under a take-and-pay contract structure. First, the buyer may be required to pay the full contract price for the quantity of LNG not taken, and then the seller would be required to resell the quantity of LNG not taken and then provide the buyer with the net proceeds of such resale, up to the contract price paid by the buyer (with the seller being entitled to retain any excess proceeds). Effectively, this remedy is akin to the seller’s “expectation damages” under applicable contract law, except that the buyer typically pays the contract price up front before receiving any credits from the resale by the seller. Of course, the buyer would much rather require the seller to first resell the quantity of LNG not taken by the buyer then assert a damages claim against the buyer for the negative difference (if any) between the resale value and the original contract price. However, this is not a position commonly accepted by sellers since it effectively gives the defaulting buyer a longer credit period to pay for scheduled LNG quantities. Further, by having the defaulting buyer pay the full contract price first at the time of its performance failure, this variation of the take-and-pay contract structure can arguably provide the certainty of revenue stream required to support the seller’s project financing.

The other remedy under a take-and-pay contract structure involves an obligation of the buyer to pay the seller fixed damages assessed against the value of the quantity of LNG not taken, with such payment accruing at the time the buyer fails to take such quantity of LNG. Effectively, the fixed damages are a pre-agreed liquidated damages amount to compensate the seller for the buyer’s failure to take the required quantity. From the seller’s perspective, the fixed amount must be sufficient to cover the fixed, unavoidable costs it is reasonably likely to incur from the buyer’s failure to take. Such a sufficient fixed amount would arguably provide the steady revenue stream necessary to support project financing. With this type of take-and-pay contract structure there is often a risk that the amount of liquidated damages chosen by the parties may later be challenged by the buyer as being an unenforceable penalty if such amount can be shown to sufficiently deviate from the harm, or likely harm, suffered by the seller as a result of the buyer’s failure to take the required quantity. As such, we would strongly advise any seller that desires to use this second formulation to first confirm the enforceability of the applicable liquidated damages amount or formula under applicable law before contractually establishing the amount of the fixed damages.^[6]

Regardless of which formulation of take-and-pay contract structure is chosen, from the seller’s perspective the use of a take-and-pay contract structure provides two additional benefits over the take-or-pay contract structure. First, from a cash flow standpoint, the take-and-pay remedies are typically settled on a per-cargo basis and the buyer’s liability applies to each cargo (or portion thereof) that it fails to take. As mentioned above, under the take-or-pay contract structure, the buyer’s liability for a take-or-pay payment is typically calculated and becomes payable on an annual basis at the end of each measurement period. This means that if the buyer fails to take multiple cargoes (or portions thereof) during a contract year, there is no financial impact to the buyer  until the end of the applicable measurement period. On the other hand, the seller’s use of a take-and-pay contract structure under which the buyer’s performance failures result in real-time payment obligations can actually provide the seller with a more regular and timely cash flow stream. Because of the more immediate and prompt settlement of the buyer’s payment liabilities arising from its failure to take the required quantities of LNG under an alternative take-and-pay contract structure, the seller also has significantly less exposure to the buyer’s shorter-term credit risks. This protection is enhanced when this contract structure is coupled with an additional right of the seller to exercise an interim performance suspension right that is triggered immediately when the buyer breaches its payment obligation, in addition to the seller’s traditional contract termination rights that become available after formal notice has been given by the seller and the buyer has not cured the payment default by the expiration of the applicable cure period.

Second, in respect of reduced quantity fluctuations, a buyer typically has no right to schedule and receive make-up quantities under a take-and-pay contract structure, since the payment made by the buyer at the time of its performance failure is designed to compensate the seller for the value of its loss, as opposed to giving the seller the full contract price for the untaken quantity without regard to its eventual resale. In other words, the buyer’s failure to take a cargo (or a portion thereof) is settled monetarily at the time such failure occurs. This means the seller need not withhold certain amount of excess production capacity at its LNG export project to ensure that it can meet its contractual obligation to schedule and deliver make-up quantities, nor will the seller have to shift vessels in its fleet to deliver make-up quantities. This is perhaps the primary reason why portfolio sellers appear to strongly prefer the take-and-pay contract structure over the more traditional take-or-pay contract structure.

Further, there is generally less quantity flexibility given to the buyer under a take-and-pay structure as compared to a take-or-pay structure. While a take-and-pay contract may be based on an ACQ which is then converted to a specific number of scheduled cargoes, it may also be based solely on a specified number of scheduled cargoes. Of course, the amount of flexibility is subject to negotiation but, as a general observation, a take-and-pay contract typically provides for fewer and more limited quantity flexibility mechanisms than that of a traditional take-or-pay contract.

On the downside, there appears to be very little precedent for the take-and-pay contract structure involving a project-financed LNG export project. A seller who wishes to utilize this structure likely would need to first educate its lenders in order to overcome the long-standing tradition and preference of the project lender community for the traditional take-or-pay contract structure, notwithstanding the potentially enhanced credit risks that it may entail when a buyer’s shortfall payment obligations are measured on an annual, rather than on a per-scheduled cargo, basis. Notwithstanding this established lender bias, we are of the view that a take-and-pay contract structure can be successfully developed and implemented in a manner that provides the seller with a sufficiently steady and reliable stream of revenue in order to adequately support even a large project financing.

In addition, under the take-and-pay damages formulation in which the seller must mitigate and resell quantities of LNG not taken by the buyer, the seller arguably may take on more risk that it will have to resell the cargo at a heavy discount, particularly at times when the market is heavily skewed towards buyers, as it has been in recent years. In the case of such a mitigation resale (versus the liquidated damages remedy), the seller may in some cases face a higher risk of dispute with the original buyer centered on whether or not the seller acted reasonably in undertaking to get the highest possible resale price under its mitigation resale.

Alternative 2: Take-or-Cancel Contract Structure

The other alternative structure is a take-or-cancel structure, which is a somewhat new type of contract structure that has evolved out of the recent proliferation of  U.S.-based LNG export projects fed by a highly liquid and deep domestic pipeline feed gas system. Under this type of contract structure, the buyer has the option not to take its contracted quantity with sufficient advance notice given to the seller and the payment of a cancellation fee. From a legal perspective, the buyer is legally relieved of its obligation to take the cancelled quantity by exercising its cancellation option. In other words, the fee is not a remedy for the buyer’s failure to perform its contractual obligation to take LNG, but it is instead treated as an option payment.^[7]

From the seller’s perspective, the cancellation fee must be sufficient to cover the seller’s fixed, unavoidable costs so as to protect the seller should the buyer elect to cancel all of its contract quantities for a given performance period (typically measured in contract years). Thus, this structure can also be described as a synthetic toll, whereby the cancellation fee serves the same function as that of a tolling fee under a tolling contract.^[8]  Thus, similar to fixed damages, an appropriate level of cancellation fees can arguably provide a seller with a sufficiently steady and predictable revenue stream necessary to support its project financing. Further, if properly structured and documented, a take-or-cancel contract may arguably be somewhat more insulated from a legal attack by a buyer that argues that such cancellation fee amounts to an unenforceable penalty.^[9]

Aside from the legal distinction discussed above, the take-or-cancel contract structure shares similar benefits with that of the take-and-pay contract structure; namely, cash flow regularity (as the cancellation fee is typically payable upon exercise) and reduced quantity fluctuation (given the lack of make-up rights and generally very limited or no other quantity fluctuation rights). That being said, because the cancellation right itself gives the buyer a high level of quantity flexibility, it does impose a higher burden on the seller to manage the potential for cargo cancellations by the buyer. To mitigate this burden, a key negotiation point will be the amount of advance notice required for the buyer to exercise its cancellation right.

Because a U.S. LNG export project typically is not tied to a dedicated upstream gas supply source, but is instead supplied by a robust and interconnected domestic gas market with numerous supply and transportation options at its disposal, a U.S.-based LNG seller has the option not to produce the cargoes that the buyer elects (and pays) to cancel. Accordingly, the amount of advance notice of cancellation from the buyer should take into consideration the amount of time that will typically be required by the seller to cancel, defer or resell a corresponding quantity of upstream feed gas supplies. In contrast, a more traditional, non-U.S. based, LNG export project typically is developed as a means to monetize dedicated, and often quite stranded, upstream natural gas reserves. Thus, shutting in upstream production typically is a matter of last resort, undertaken primarily for safety reasons and not as an option to be exercised by any party for commercial benefit. In such a case, any cargoes that a buyer desires to cancel will nonetheless be produced by the seller in order to maintain sufficient reservoir pressure and otherwise facilitate safe and efficient upstream gas production operations. Accordingly, the key consideration for the amount of advance notice that would be required for a seller operating from a more traditional, non-U.S. based, LNG export project is to give the seller sufficient time to locate an alternative buyer for the cancelled cargoes.

From a project financing perspective, the take-or-cancel contract structure has been used successfully by Cheniere Energy to finance its Sabine Pass and Corpus Christi LNG export projects in the U.S. That being said, there is little or no precedent for this type of contract structure in the financing of traditional greenfield LNG export projects with dedicated upstream reserves. While the applicable cancellation fee can be structured to provide a steady and predictable stream of revenue necessary to support project financing, the amount of any cancellation fee that a buyer may be willing to pay in a more traditional non-U.S. based greenfield LNG export project likely will not be sufficiently large to cover the seller’s upstream costs or to address related financial issues, such as the obligation of the seller to pay government royalties. Accordingly, in such a case the seller’s project lenders are likely to scrutinize in closer detail the seller’s mitigation plan in case of a large quantity of cancelled cargoes in a saturated market. For this reason, we believe any take-or-cancel structure employed in a traditional, non-U.S. based, project-financed LNG export project is likely to require fairly limited cancellation rights, fairly long advance notice periods, and a fairly high cancellation fee.

Conclusion

As the so-called buyers’ market in LNG has persisted over the past several years, a large number of long-term LNG sales contracts have been concluded with portfolio sellers. One of the more notable results of this occurrence has been a movement away from the traditional take-or-pay contract structure and the emergence of alternative contract structures such as the take-and-pay and take-or-cancel contract structures. The recent popularity of these alternative contract structures tends to support the conclusion that many LNG buyers that have been seeking to break away from the traditional take-or-pay contract structure now have a few viable alternatives to consider. The recent JFTC report criticizing the traditional contract structure and questioning its continued viability under Japanese competition laws (notably, in the country in which the majority of LNG has been, and for the near term will be, sold) further underscores the fact that serious cracks now may be forming in the very foundation of the LNG industry’s previously constructed contract model for selling LNG on a long-term basis. Given these recent developments and today’s buyer-oriented LNG market climate, we believe it is worthwhile for both sellers and buyers to examine these two alternative structures and determine whether one or both of these alternatives may be more beneficial to their respective commercial objectives.

[1] Please see an earlier article from our colleagues titled Japan Fair Trade Commission Survey of LNG Trades for a more detailed discussion on the JFTC findings. https://s3.amazonaws.com/kslaw-staging/attachments/000/004/639/original/ca070317.pdf?1499112600.
[2] We note that this obligation is sometimes measured on a quarterly basis, with a year-end reconciliation, but since this arrangement is not as prevalent we will instead focus on the more typical annual measurement arrangement.
[3] See e.g., Superfos Investments Ltd. v. FirstMiss Fertilizer, Inc., 821 F.Supp. 432 (D.C.Miss. 1993) (“’[T]ake-or-pay’ contracts are alternative performance contracts such that the ‘pay’ option in a ‘take-or-pay’ contract is not a penalty provision, and in fact is not a damages provision at all, but rather is one of the buyer’s performance alternatives” and a buyer’s make-up right supports the argument that a particular ‘take-or-pay’ contract provides a real alternative to taking the gas.). Note, however, a few courts have upheld a take-or-pay contract without any make-up rights (e.g., World Fuel Services, Inc. v. John E. Retzner Oil Co., Inc., 234 F.Supp.3d 1234 (D.C.Florida 2017).
[4] See e.g., M & J Polymers Ltd v. Imerys Minerals Ltd, [2008] EWHC 344 (Comm); E-Nik Ltd v. Department for Communities, [2012] EWHC 3027 (Comm).
[5] Portfolio sales and purchases refer to those made by a seller that typically supplies the LNG from various LNG export projects in which it or its affiliates participate and are entitled or required to lift a share of the total LNG production.
[6] See e.g., UCC §2-718, which applies to contracts for the sale of LNG that are governed by U.S. jurisdictions (such as New York) that have adopted the Uniform Commercial Code: “Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or non-feasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably large liquidated damages is void as a penalty.”
[7] This cancellation right arguably may also be contractually structured to be an alternative performance (see footnote 3).
[8] A tolling contract can be described as one where a customer has the right (but not obligation) to use liquefaction services at an LNG export project to produce LNG. The customer must pay a fixed tolling fee each month for its right to such services irrespective of whether or not it actually uses such services.
[9] See e.g., Davidowitz v. Partridge, No. 08 Civ. 6962 NRB, 2010 WL5186803, *6 (S.D.N.Y., Dec. 7, 2010) (Under New York law, the parties’ agreed consideration is generally respected, even if such consideration is “grossly unequal”.)