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8 July, 2017
The Japan Fair Trade Commission (JFTC) has published the findings of its survey1 on the impact on competition, and the potential consequences under the Japanese Antimonopoly Act,2 of destination restrictions, diversion conditions and profit sharing provisions in long term LNG sale and purchase agreements (LNG SPAs) into Japan.
The JFTC commenced a survey of various domestic and foreign LNG market participants3 in July 2016 to investigate whether destination restrictions in LNG SPAs could be in contravention of the Japanese Antimonopoly Act. Japan's Ministry of Economy, Trade and Industry (METI) had also previously highlighted destination restriction clauses in LNG SPAs as one of the key obstacles to the development of a global liquid LNG market, and the subsequent JFTC inquiry has drawn sustained interest from global LNG industry participants over the past year as Japan is the largest LNG importing country in the world.4
In particular, LNG industry participants had initially expressed significant concerns over whether the JFTC findings would impact existing LNG SPAs, and the potential knock-on effects on the global LNG market.
Key findings of the JFTC survey include:
- FOB Contracts
- Destination restrictions and diversion conditions
Destination restriction clauses are not "necessary and reasonable" in LNG SPAs which provide for "free on board" delivery (FOB Contracts), on the basis that:
(a) the delivery point under the contract is at the loading terminal;
(b) the buyer is responsible and liable for the transportation of the LNG cargo from the loading terminal to the unloading port; and
(c) Destination restrictions in FOB Contracts therefore prevent buyers from freely reselling LNG, even though the buyer already has taken title and risk in the LNG cargo at the delivery point.
Accordingly:
Destination restriction clauses in FOB Contracts are "likely to be in violation of the Antimonopoly Act".
Diversion conditions and restrictions are "highly likely to be in violation of the Antimonopoly Act".
Profit sharing requirements
Profit sharing clauses in FOB Contracts are "highly likely to be in violation of the Antimonopoly Act", as such clauses indirectly prevent buyers from freely reselling LNG.
DES Contracts
Destination restrictions
Destination restriction clauses in LNG SPAs which provide for delivery "ex-ship" (DES Contracts) "are not in itself problematic" under the Antimonopoly Act as it is necessary for the delivery point/s to be specified under DES Contracts given that:
- the delivery point under the contract is at the buyer's unloading terminal;
- the seller is responsible and liable for the transportation of the LNG cargo from the loading port to unloading port; and
- title and risk to the LNG transfers to the buyer at the delivery point (buyer's unloading terminal).
Diversion conditions
The inclusion of certain conditions to the diversion of an LNG cargo by a buyer under DES Contracts is "not in itself problematic" under the Antimonopoly Act, for example:
- requirements for ship-shore compatibility and safety of buyer's receiving terminal;
- buyer's payment of actual incremental costs incurred by the seller as a result of the diversion; and
- no adverse and material impact on seller's annual delivery program or shipping operations.
However, some diversion conditions can have the effect of restraining competition and such requirements are "highly likely to be in violation of the Antimonopoly Act". Examples of such diversion conditions identified in the JFTC survey as restraining competition include the following:
- seller's right to withhold its consent to a buyer's diversion request at seller's sole discretion and for any reason;
- diversions being only permitted for buyer's operational reasons;
- prohibition on diversions for commercial reasons;
- prohibition on diversions for resale to seller's other customers; and
- prohibition on buyer's resale of the relevant cargoes (i.e., diverted cargoes may only be sold by seller to the relevant third party buyer).
Profit sharing
The inclusion of profit sharing clauses under a DES Contract is not unreasonable and "is not in itself problematic" under the Antimonopoly Act, even though such clauses indirectly prevent the buyer from reselling the LNG cargo on the basis that title and risk in the LNG cargo remain with the seller until the delivery point (at the unloading terminal). It is not unreasonable for a DES seller to be compensated for agreeing to amend or vary an existing contractual requirement.
However, profit sharing clauses which:
- provide for an unreasonable profit sharing between the parties without considering seller's contribution to the resale or by using gross profit as the basis for the profit sharing;
- do not clearly define the method and percentage for profit sharing; or
- prevent the buyer from reselling due to seller's request for disclosure or the buyer's profit or cost structure, are "likely to be in violation of the Antimonopoly Act".
Take or pay
Given the need for sellers to guarantee and protect the large initial investment required for LNG projects, take or pay clauses in LNG SPAs have some justification and "providing for such clauses is not in itself problematic under the Antimonopoly Act".
However, take or pay clauses and strict minimum purchase obligations are "likely to be in violation of the Antimonopoly Act" where they are imposed by the seller unilaterally and without sufficient negotiation as a result of the seller's superior bargaining power, and after the seller has realised a sufficient return on initial investment.
Some initial takeaways
Forward looking
The JFTC survey focusses on and expressly warns against the inclusion of "competition restraining" destination restrictions, diversion conditions and profit sharing clauses in new LNG SPAs which are yet to be signed, as well as in the case of the extension and renewal of existing contracts. However, the JFTC survey does not expressly contemplate a general reopening or revision of such provisions in existing LNG SPAs. Whilst this result was largely expected, the forward looking focus of the survey's conclusions gives some much needed certainty and we expect this will be welcomed by industry participants, particularly given the strong desire not to upset the contractual equilibrium that has previously been reached between parties.
The JFTC's response can be contrasted with the responses by the European Competition Commission, during its analogous review of destination restrictions in certain EU gas contracts during the early 2000s. This process resulted in the re-opening of numerous LNG SPAs which included destination restriction clauses that the Commission deemed to be anti-competitive from a EU competition law perspective. The resulting contract renegotiations between the sellers and European based buyers saw the removal of destination restrictions from the identified contracts.
Notwithstanding the forward looking nature of the survey, it would still be open for the JFTC to commence formal investigations in relation to existing destination restriction clauses (particularly those in FOB Contracts) that are identified as likely to be in violation of the Antimonopoly Act. The JFTC also urged LNG sellers under existing LNG SPAs to review any competition restraining business practices. In particular, the report contemplated that a seller's refusal to consent to a buyer's diversion request that otherwise met the diversion requirements under the relevant contract could be a violation of the Antimonopoly Act.
On balance, this appears to be a pragmatic approach taken by the JFTC. In addition to the desire to respect existing agreements reached between sellers and buyers, logistically, it would have been implausible and extremely disruptive to re-open and renegotiate contracts given the large number of LNG SPAs with LNG buyers in Japan. Even without amendments to existing LNG SPAs, LNG sellers, particularly those with FOB contracts, are likely to be more cautious in interpreting and enforcing the destination restrictions, diversion conditions and profit sharing clauses under their sales agreements given the potential competition restraining impact highlighted in the JFTC survey. Going forward, Japanese buyers also have a clear basis to discuss the necessity and form of such clauses in future LNG SPAs.
The JFTC also indicated that it will "keep monitoring" the market and "take strict actions against any violations of the Antimonopoly Act". Although it does not specify what actions may be taken, it is worth noting that the JFTC has previously exercised extraterritorial application of antimonopoly law, albeit in the context of international cartel investigations.5 It therefore remains to be seen how far the JFTC may extend its reach in the future. That said, sellers based outside Japan should be wary when negotiating the relevant clauses with buyers importing cargoes to Japan.
Balancing act
The JFTC report made a clear distinction between FOB and DES delivery contracts when analysing the application and impact on competition of destination restriction, diversion and profit sharing clauses. In particular, the report considered the differences in when title and risk in the LNG cargo at the delivery point would pass, as well as which party would be managing the shipping of the LNG cargo.
This is in our view consistent with the commercial and practical realities of both FOB and DES delivery contracts. It also has some historical precedent as a broadly similar distinction was made by the European Competition Commission in a case involving profit sharing mechanisms in gas contracts entered into between Algerian gas sellers and EU importers.6
Take or pay
In contrast with the findings on destination restrictions, diversion conditions and profit sharing, the JFTC survey does not set out a clear way forward with respect to take or pay clauses in long term LNG SPAs from a competition law perspective. On one hand the JFTC report contemplates that such take or pay clauses may be "necessary and reasonable", but then goes on to state that such clauses may in some cases be in violation of the Antimonopoly Act if a seller's bargaining position is "superior to that of a buyer" and if the clauses are unilaterally imposed on a buyer.
The JFTC's comments on the potential anti-competitive nature of take or pay clauses may take some industry participants by surprise given that such clauses are not directly relevant to the level of destination or resale flexibility that a Japanese buyer may have, and further clarifications from the JFTC would be welcome. Attempts to apply consumer protection principles may be considered by some as being unsuitable in the context of high value LNG SPAs that are typically negotiated between sophisticated commercial parties.
Relevant considerations include:
- Take or pay clauses are a common feature of long term LNG SPAs (as well as various other energy sales contracts) and the JFTC survey recognises the commercial rationale for their inclusion in LNG SPAs;
- The agreement of the parties to schedule LNG cargoes under the annual delivery programme of an LNG SPA reinforces the contractual commitment of the seller to deliver and sell LNG cargoes and the buyer's obligation to take and pay for such cargoes. Failure by the buyer to take a scheduled cargo results in a breach of the buyer's contractual commitment and therefore entitles the seller to damages resulting from this breach;
- There are also typically other mitigating rights under LNG SPAs, such as the potential for the parties to agree on cargo rescheduling, buyer's downward quantity flexibility and cargo cancellation rights;
- As a quid pro quo, should a seller's deliver or pay obligation, as a result of the seller's failure to deliver a scheduled cargo, be revisited in exchange for removal or modification of a buyer's typical take or pay liability. This could result in potential security of supply concerns for buyers;
- A fundamental principle of English law, which governs a large proportion of LNG SPAs, is that the court will not review the fairness of an agreed bargain between commercial parties.
Whilst under English law an obligation to pay a sum of money upon a breach of contract (e.g. failure to take LNG) will not be enforced if the payment obligation is out of all proportion to any legitimate interest in enforcing the obligation which has been breached, LNG SPAs typically mitigate the risk of this by giving the buyer a right to take "make up" cargoes at a later date and/or passing through to the buyer the benefit of any third party mitigation sales which the seller may be able (and is often required) to enter into; and
Important distinctions may also need to be made between LNG SPAs which impose take or pay on an annual basis, and those which impose take or pay on a cargo by cargo basis.
Linkage between price and destination flexibility
An interesting conclusion reached by the JFTC as part of its survey is that empirical analysis did not indicate any significant correlation between price and destination flexibility. The JFTC did however note that such a correlation existed in the case of buyer upward quantity flexibility.
Historically, sellers have often justified and linked the LNG pricing with buyer's destination flexibility. During the JFTC study period, a number of LNG sellers commented that if destination restrictions were to be removed from existing contracts, sellers may require an increase to the LNG price under those contracts.
Conclusion
Whilst the conclusions reached by the JFTC as a result of its survey have direct application to LNG buyers in Japan, we anticipate that buyers in other countries, particularly in Asia, will also reference the JFTC's comments and conclusions when negotiating destination restrictions, diversion conditions and profit sharing provisions in new LNG SPAs. As a result, a clearer market practice may emerge in the future in relation to such provisions.
1. The Japan Fair Trade Commission: Survey on LNG Trades (Chapter 4 Ensuring fair competition in LNG Trades), June 2017. As at the date of this briefing note, the full report is only available in Japanese.
2. The Act on Prohibition of Private Monopolization and Maintenance of Fair Trade, as enacted in 1947, as supplemented and amended.
3. The JFTC reported that its survey involved questionnaires to various LNG market participants forming approximately 95 per cent of the Japanese market, including 14 Japanese users, 6 foreign users and 32 domestic and foreign suppliers, as well as interviews with various LNG users and suppliers.
4. Japanese buyers accounted for around 31% of global LNG imports in 2016 (net of re-exports), according to the GIIGNL Annual LNG Industry Report 2017.
5. For example, on 22 May 2015 the JFTC imposed fines on four CRT manufactures based in Indonesia, Malaysia and Thai for price fixing.
6. http://eupropa.eu/rapid/press-release IP-07-1074.
For further information, please contact:
Daniel Reinbott, Partner, Ashurst
daniel.reinbott@ashurst.com
