Daily Development for Monday, September 25, 2009
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law UMKC School of Law
Of Counsel: Husch Blackwell Sanders
Kansas City, Missouri dirt@umkc.edu

Although this case is somewhat dated at this point, it is one of the few cases considering and upholding the defense of “temporary commercial impracticability.” The editor has omitted much discussion of other cases that students of this issue should study by reading the original case.   The editor is indebted to his assistant Mark Dunmire for helping to “work up” this very complicated decision.   

CONTRACT LAW; PERFORMANCE; IMPOSSIBILITY OF PERFORMANCE; IMPRACTICABILITY: Under the contractual doctrine of temporary commercial impracticability, impracticability of performance or frustration of purpose that is only temporary suspends an obligor's duty to perform for the duration of the impracticability or frustration; it does not discharge the ultimate duty or prevent it from arising. Thus, temporary impracticability only relieves the promissor of an obligation to perform for as long as the impracticability lasts plus a reasonable time afterwards.

Hoosier Energy Rural Electric Cooperative, Inc., v. John Hancock Life Insurance Company, 588 F. Supp. 2d 919 (S.D. Ind. 2008)

This case provides a case study of some of the worst aspects of modern finance. The case arises from an elaborate transaction that combines the sometimes toxic intricacies of credit default swaps and investment derivatives with a blatantly abusive tax shelter. Investment bankers and lawyers made more than $ 12 million in fees for putting together the paper transaction known as a "sale in - lease out" or "SILO" transaction of an electrical generating plant. Although all parties have been making all payments required under the contracts, the transaction is now in crisis because credit rating agencies have downgraded the credit ratings of one of the parties.

At this stage of the case, plaintiff Hoosier Energy Rural Electric Cooperative, Inc. seeks a preliminary injunction to enjoin defendants (i) John Hancock Life Insurance Company, Merom Generation I, LLC, and OP Merom Generation I, LLC (collectively, "John Hancock"); and (ii) Ambac Assurance Corporation and Ambac Credit [**3] Products, LLC (collectively, "Ambac") from making any demand or any payment pursuant to any assertion that a default has occurred and enjoining John Hancock from asserting that a default has occurred.

Plaintiff Hoosier Energy owns and operates an electrical generating plant in Merom, Indiana on the Wabash River. In 2002, Hoosier Energy and the other parties entered into a complex transaction known as a "sale in - lease out" or "SILO" in which Hoosier Energy leased certain assets at its Merom power plant to John Hancock for a term of 63 years (longer than its useful life) and then leased the same assets back for a term of 30 years. John Hancock made an immediate one-time payment of $ 300 million for its 63 year lease. John Hancock then immediately leased these assets back to Hoosier Energy. Hoosier Energy kept about $ 20 million, and approximately $ 278 million was deposited with various Ambac entities, which in turn were required to make lease payments on Hoosier Energy's behalf to John Hancock. Hoosier Energy made payments into other funds controlled by Ambac with an eye toward the back end of the deal, when it would be virtually certain that Hoosier Energy would remain in con

trol of the Merom plant.

The transaction was promoted and designed by lawyers and investment bankers (transaction costs were more than $ 12 million) with the hope that it would allow John Hancock to claim to be the "owner" of the Merom plant for tax purposes and thus enable it to claim tens of millions of dollars of tax deductions. Those deductions were of no use to Hoosier Energy as the plant owner because it simply does not earn significant profits. It is a cooperative made up of members that are rural electric cooperatives.

As part of the complex transaction (documented in approximately 4000 pages of fine print), Hoosier Energy was required to obtain a "credit default swap" from Ambac to give John Hancock further assurance that it would actually receive the promised lease payments. In general terms, the parties agreed that if Hoosier Energy defaulted on its obligations under the contracts, John Hancock could demand a "termination payment" from Ambac, and Ambac could turn to Hoosier Energy for payment under a closely parallel credit default swap contract between Ambac and Hoosier Energy. Ambac also provided a surety bond for the benefit of John Hancock.

As part of the terms of this credit protection for John Hancock, the parties agreed that if Ambac's credit rating dropped below a specific threshold, Hoosier Energy would have sixty days to find a new qualified swap provider. Hoosier Energy's failure to secure a new qualified swap provider would allow John Hancock to declare a default under the contracts, to terminate the entire transaction, and to demand an early termination payment from Ambac. In that event, Ambac would be able to demand very substantial payments from Hoosier Energy. The parties agreed to a schedule for the termination payment, depending on the date of the payment. The schedule was designed to give John Hancock, in the event of termination, the "Net Economic Return" it hoped to receive from the entire transaction, based on the assumption that it would be entitled to all of the hoped-for tax benefits.

Around the time these parties closed the Merom SILO transaction in 2002, the IRS began disallowing claimed income tax deductions from taxpayers who had participated in other SILOs. Courts have decided in favor of the IRS on transactions structured similarly to the Merom SILO transaction among these parties. See, e.g., BB&T Corp. v. United States, 523 F.3d 461, 477 (4th Cir. 2008) ("LILO" or lease in-lease out); AWG Leasing Trust v. United States, 592 F. Supp. 2d 953, 2008 U.S. Dist. LEXIS 42761, 2008 WL 2230744 (N.D. Ohio May 28, 2008) (SILO). The IRS had gone so far as to offer a form of tax amnesty for parties to similar SILO and LILO transactions, which the IRS deemed abusive tax shelters. The IRS announced that taxpayers involved in more than 80 percent of the SILO and LILO transactions had accepted the offer. John Hancock apparently chose not to take advantage of this offer, at least with respect to the Merom SILO transaction.

Notwithstanding the tax problems, the IRS apparently had not yet examined the Merom deal or challenged John Hancock's claimed tax deductions that appear to have been in the tens of millions of dollars so far. All parties to the transaction made all payments required under the contracts.

In June 2008, however, Ambac's published credit rating fell below the level specified in the contract documents. Hoosier Energy was notified of this change, recognized that the contract required it to find a new participant with comparably strong credit ratings, and began looking. It encountered extraordinary difficulty in doing so. As the court stated, the 2008 credit "tsunami" appeared to bet  he primary reason that Ambac's credit rating fell. The credit crisis also appears to have made it impossible - or nearly impossible - for Hoosier Energy to find a substitute for Ambac with a sufficient rating, on time, and at any price.

In December 2007, nine of the thirteen financial guarantors tracked by Moody's and Standard & Poor had ratings that satisfied the criteria of the Merom SILO agreements. In the summer and fall of 2008, credit markets experienced unparalleled adverse events. By June 2008, only three of those thirteen guarantors had the requisite ratings. The crisis was not anticipated by the most senior economists in the country.

On June 19, 2008, Moody's downgraded Ambac to a rating of Aa3, which gave Hoosier Energy sixty days to replace Ambac in the credit default swap arrangements. Hoosier Energy immediately began trying to replace Ambac with a credit enhancement vehicle that would meet the credit conditions of the Merom SILO agreements.

Hoosier Energy informed John Hancock of these efforts by letter on June 20, 2008 but warned that it could take more than sixty days to secure a replacement because of the extraordinary state of the credit markets. Hoosier Energy also proposed potential solutions to the situation, including allowing Hoosier Energy more than the sixty days contemplated in the Agreement to secure a replacement, granting waiver of the Aa2 credit rating requirement, restructuring the transaction without credit enhancement requirements, and unwinding the transaction altogether. Hoosier Energy, John Hancock, Ambac, and CoBank conferred on July 10th, and John Hancock appeared to support Hoosier Energy's efforts in the face of the credit crisis. However, on July 21st, John Hancock rejected the proposals Hoosier Energy outlined in its June 20th letter, including permitting Hoosier Energy additional time to find a replacement for Ambac.

Hoosier Energy's efforts continued, and by August 6th it had made progress in negotiating with Bank of America and CoBank for letters of credit in amounts equal to the equity portion of the termination value. Hoosier Energy informed John Hancock of this development. John Hancock responded positively, stating that it would accept the proposed letters of credit but that it preferred to have Bank of America support the entire amount. John Hancock also stated that it would extend the replacement period until September 2nd, contingent on production of either signed term sheets or letters of intent from Bank of America and CoBank. However, Bank of America decided not to proceed with the credit enhancement for the Merom SILO transaction.

On October 3rd, John Hancock agreed to extend the replacement period, but only by twenty days. Hoosier Energy attempted to accelerate the finalization of a new deal with Berkshire Hathaway. On October 13th, its board of directors voted to approve the term sheet, and the Berkshire Hathaway term sheet was executed. Hoosier Energy forwarded a copy of the executed term sheet to John Hancock. The replacement period was due to expire on October 22nd, and Hoosier Energy sent a draft Third Waiver Extension Agreement to John Hancock that would extend the replacement period by another 90 days. John Hancock did not respond. Also on October 22nd, Hoosier Energy was reassured that although Berkshire Hathaway senior management needed to approve the deal, Berkshire intended to close the deal. Hoosier Energy informed John Hancock of Berkshire's intent.

On October 23rd, however, the same day that Alan Greenspan testified about the "credit tsunami," John Hancock pulled the plug on Hoosier Energy's effort to replace Ambac. John Hancock rejected Hoosier Energy's request for an additional extension and informed Hoosier Energy that an "Event of Default" had occurred under the contract. John Hancock advised Ambac that it would expect its termination payment of approximately $ 120 million on October 31, 2008. Such a payment would immediately trigger a duty on the part of Hoosier Energy to pay Ambac either the same sum of approximately $ 120 million immediately, or at least $ 26 million immediately, followed by installment payments over four years for total payments of approximately $ 160 million. Ambac stated that it was ready, willing and able to make the $ 120 million termination payment to John Hancock unless it enjoined from doing so.

Hoosier Energy did not argue that the credit crisis should forever excuse its obligation to replace Ambac as a credit swap partner. Hoosier Energy argued that, given the extraordinary but temporary circumstances presented by the credit crisis, it was entitled to a reasonable period of additional time to replace Ambac under the doctrine of temporary commercial impracticability.

The court cited the commentary of an earlier case supporting the “commercial impracticability defense” and stating its basic principles

 "In the overwhelming majority of circumstances, contractual promises are to be performed, not avoided: pacta sunt servanda, or, as the Seventh Circuit loosely translated it, 'a deal's a deal. . . . Even so, courts have recognized, in an evolving line of cases from the common law down to the present, that there are limited instances in which unexpectedly and radically changed conditions render the judicial enforcement of certain promises of little or no utility. This has come to be known, for our purposes, as the doctrines of impossibility and impracticability. Given the importance of the principle that courts respect and enforce parties' valid and lawful contracts, these are doctrines that must be employed with great caution, but they retain a place in the law under sufficiently extreme circumstances.”

To assert the affirmative defense of commercial impracticability, "the party must show that the unforeseen event upon which excuse is predicated is due to factors beyond the party's control." Temporary commercial impracticability excuses performance until circumstances have changed, plus a reasonable time afterwards:

Impracticability of performance or frustration of purpose that is only temporary suspends the obligor's duty to perform for the duration of the impracticability or frustration; it does not discharge the ultimate duty or prevent it from arising. Thus, temporary impracticability only relieves the promisor of an obligation to perform for as long as the impracticability lasts plus a reasonable time 

John Hancock countered that an economic crisis cannot support a defense of impracticability, and that if that argument prevailed, "every debtor in a country suffering economic distress could avoid its debts.". John Hancock also relied heavily on Kel Kim Corp. v. Central Markets, Inc., 70 N.Y.2d 900, 519 N.E.2d 295, 524 N.Y.S.2d 384 (N.Y. 1987), in which the court refused to excuse a tenant's failure to provide liability insurance when, due to a liability insurance crisis, the tenant was unable to secure the level of insurance required by the lease. The court found that the tenant's "inability to procure and maintain requisite coverage could have been foreseen and guarded against when it specifically undertook that obligation in the lease. . . ." John Hancock argued that it was not actually impossible for Hoosier Energy to find a replacement for Ambac, and that in any event, Hoosier Energy should have foreseen and guarded against its inability to find a replacement.

The instant court concluded that if the nature and scope of the credit crisis were more limited or a “mere economic downturn,” John Hancock's argument that the crisis was foreseeable or that Hoosier Energy should have protected itself better might be more persuasive. However, court noted, the credit crisis facing the world's economies in recent months is unprecedented and was not foretold by the world's preeminent economic experts. The crisis certainly was not anticipated in 2002, when the deal between Hoosier Energy, Ambac, and John Hancock was being finalized. “Retrospect will not assist John Hancock here, nor will an assertion that it was Hoosier Energy's responsibility to prepare for and guard against any imaginable commercial calamity. [the court quoted John E. Murray, Jr., Murray on Contracts 112 at 641 (3d ed. 1990) ("If 'foreseeable' is equated with 'conceivable', nothing is unforeseeable."]. Hoosier Energy , the court concluded, had come forward with evidence indicating t

hat the obstacles it faced were not specific to Ambac but were the product of the credit crisis that effectively but temporarily froze the market for comparable credit products at any price. Those effects were not anticipated and could not have been guarded against.

John Hancock pointed out that Hoosier Energy had been reluctant to accept terms offered by Berkshire Hathaway because the deal would have been, in Bernardi's words, "prohibitively expensive." Expensive does not mean impossible or impracticable. But the evidence shows that on October 13th, Hoosier Energy signed the term sheet for those "prohibitively expensive" terms, forwarded that information to John Hancock, and asked for time to close the deal. Thus, Hoosier Energy's temporary commercial impracticability argument seems to depend on the logistics of closing another complex deal, not on the expense of that deal.

Unlike the defendants in other cases that had denied the defense of commercial impractibability,  Hoosier Energy did not ask John Hancock to excuse its performance for an uncertain or unlimited period of time. In the midst of unprecedented economic tumult, Hoosier Energy had made significant headway in securing Ambac's replacement, even at what Hoosier Energy described as a prohibitive price. But even after credit markets began to thaw, Hoosier Energy needed an additional ninety days to finalize the $ 120 million deal with Berkshire Hathaway, a deal that was already on the table. John Hancock pointed out that Hoosier Energy, by contract and with agreed extensions, had already had more than 120 days to replace Ambac. John Hancock contended that it was not obligated to grant Hoosier Energy unlimited extensions. Unlimited extensions, no. But reasonable extensions, in a time of economic crisis and under the doctrine of temporary commercial impracticability, yes. The Berkshire Hathaway

 deal, before John Hancock turned out the lights, was not theoretical or speculative. The preliminary terms had been executed and Berkshire Hathaway had indicated its intent to proceed. Under any circumstances, ninety days does not seem an unreasonable amount of time to finalize a complicated $ 120 million deal. Given the state of economic affairs on October 23rd, when John Hancock refused the extension, ninety days appears to have been a reasonable request. The court held that Hoosier had shown a reasonable likelihood of success on the merits on its defense of temporary commercial impracticability.

John Hancock pointed out correctly that if the court granted injunctive relief, it would be exposed to credit risks greater than those it agreed to accept. That exposure reflected potential harm to John Hancock, but that potential harm paled next to the virtual certainty of the serious irreparable harm that an erroneous denial of injunctive relief would have inflicted on Hoosier Energy and its constituent REMCs. In addition, even in the unlikely scenario in which Ambac would be unable to satisfy its obligations, John Hancock had an over-collaterized mortgage and security interest in the Merom plant. That security is less liquid than the credit default swap with Ambac, but it nevertheless provided substantial security.

The character of the Merom SILO transaction as an abusive tax shelter also factored into the court's weighing of the equities. John Hancock understandably pointd out that Hoosier Energy happily entered into the transaction and received some $ 20 million in cash at the front end, and had not complained about the tax aspects of the transaction until now. John Hancock argued that the court should not interfere with Ambac's payment on its credit default swap with John Hancock and should defer consideration of Hoosier Energy's defenses to a later lawsuit between Ambac and Hoosier Energy. That approach would probably have resulted in a great inequity if Hoosier Energy's challenge to the legality of the transaction were sound. John Hancock would walk away with the economic equivalent of the tax windfall it hoped to gain. Ambac would be left unable to collect from Hoosier Energy on the theory that the obligations of this entire transactions are void and that the courts should leave the pa

rties where they find themselves. Yet John Hancock is the party who, in effect, tried to buy tax deductions it was not entitled to and who knowingly accepted the risk that the transaction might be deemed a sham and an abusive tax shelter.

The court considered whether it should simply deny all relief on a theory of "unclean hands." After all, Hoosier Energy was itself a party to the transaction it claimed to be a sham. If the court reached a final decision that the transaction was a sham, the court would face some challenging problems in crafting any appropriate remedies. But the court concluded that the more prudent, risk-minimizing course at this point is to grant injunctive relief to prevent irreparable harm and to sort out later the difficult terms of final equitable relief (such as addressing Hoosier Energy's $ 20 million in up-front benefits from the transaction).

Consequently, the court granted the requested injunctive relief.

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