A Brief Introduction About the Take or Pay Contract
What is a take or pay contract? A take or pay contract that needs the buyer to either buy or receive a minimum amount of a product. This contract might also require paying for this minimum without taking immediate delivery. A take-or-pay contract is frequently utilized in the energy as well as oil-and-gas businesses.
Take-or-pay contracts usually signed by corporations when their suppliers need them to buy a certain amount of items through a specific date, and a penalty is imposed if they do not. In this type of contract, the seller is protected from possible loss of money from the production of the product that the buyer was supposed to buy.
A Take or pay contract provisions are usually included between corporations with their suppliers, which need that the purchasing corporation takes a stipulated supply of products from the supplier by a certain date, at the risk of paying the penalty to the supplier if they don’t carry out so. This agreement primarily benefits the supplier by reducing the hazard of losing money on any capital spent to produce whatever good they are trying to sell.
Who Takes the Take or Pay Contract?
A take-or-pay contract is an agreement that is made between a buyer and seller, in writing, that needs the buyer to pay even if the seller fails to give the item or service. Usually, the buyer is not obliged to pay the full amount, but the aim is to protect the seller in case the buyer decides to reject the goods or services at the time of delivery.
Purpose of the Take or Pay Contract
The provision in a take-or-pay contract is made to facilitate predictable outcomes from a financial perspective, mainly when debt is involved. In case a supplier needs a loan to finance the production of a buyer’s order, the lender might be unwilling to give the funds needed without a take or pay provision in the contract. This provision makes sure that the supplier would be able to pay the loan as anticipated.
The energy sector makes many uses of take-or-pay provisions since supplying the energy needs large overhead investment in natural gas, crude oil, or additional resources. Without this means of guarantee that they would have some return on their investment, they would have no spur to spend capital upfront for production.
Because of the unpredictability of energy markets, where the cost might fluctuate due to demand vs. supply, the sellers depend on take-or-pay contracts to guarantee their revenue is secured and constant. For suppliers of energy who use pipelines, oil, or natural gas to produce electricity, the huge expenses of overhead need some assurance that they would receive income as expected over the long term.
[Also Read: Oil and Gas Lease Agreement]
Three aspects make clear the requirement for take or pay provisions in energy supplier contracts:
- Energy projects need high expenses for capital.
- Energy projects happen over long periods, potentially 20 to 30 years, and generally, need loans to fund them. Thus, they are required to make sure their investments are recovered, and they could pay the lender for the sum borrowed plus accruing interest.
- With a take-or-pay provision, the buyer has no option but to accept delivery of the minimum quantity or pay for the difference amid what was agreed upon and what is accepted.
Contents of the Take or Pay Contract
A take-or-pay contract usually does help the parties in certain ways, they are;
- It protects the seller’s stream of revenue.
- It convinces the bank to grant financing for the project.
- It facilitates decision-making as well as planning, mainly regarding budgets.
- It minimizes hazard to the seller by transferring some of it to the buyer.
- It assists in mitigating other expenditures, some of which are unforeseen and unpredictable.
- It also eliminates rivalry for the term of the contract.
- It creates less of an impact on the credit-worthiness of the seller.
How to Draft the Take or Pay Contract?
A take or pay contract template is a written document, where one individual has the responsibility of either taking delivery of products or paying a specified amount.
Take or pay contracts also include clauses that describe under which circumstances they would be renegotiated. These contain the following:
- Force majeure clause, also known as the “act of God,” which should state a requirement for notice to be provided, the types of situations that shall constitute force majeure, and the effect of the event on both parties’ obligations.
- Price clause, which safeguards both parties against unforeseen fluctuations in market prices. This contains the price escalation clause and price reopener clause.
- Review clause, which is subjected to a long-term contract to regular renegotiation every few years.
Because take or pay contracts are long-standing agreements, they are susceptible to unforeseen events that were not covered in the contract. Such external events may contain political situations, commercial developments, geological occurrences, and so forth. When any of these events take place, the contract might no longer be practical or workable for one or both parties. In this circumstance, one of the parties might terminate or withdraw from the contract.
However, maintaining the take-or-pay contracts often has been beneficial for both parties, even if an unexpected event should occur. It is better for both parties to be rational and cooperative and must maintain a good reputation within the industry and amongst the business community. Thus, most firms, governments, and additional entities would allow for renegotiation when external events cause disruption.
Benefits and Drawbacks of the Take or Pay Contract
A take or pay contract is usually rule structuring negotiations that are made between corporations and their suppliers. With this type of contract, the corporation either takes the product from the supplier or pays the supplier a fine. Also, up to an agreed-upon ceiling, the corporation has to pay the supplier even for goods they do not take.
Benefits of a take or pay contract
- It lessens the risk to the corporation’s suppliers, in return for which the corporation could ask to pay less.
- It lessens the supplier’s rival’s incentive to come after the corporation’s customers by making retaliation a near certainty.
Drawbacks of a take or pay contract
- It increases the severity of the price war if deterrence fails.
- It also increases the risk of market foreclosure through a strong obstruction for new entrants seeking to join the market, and this lessens rivalry, raises costs for consumers and is likely to lead to a huge economic loss for the society.
What Happens in Case of Violation?
A take- and-pay contract obliges the buyer to both take as well as pay the contract price for a minimum quantity of commodity every year. This kind of contract is often normally known as a firm off-take contract. In case the buyer fails to take the minimum contract quantity in any period, it would be in breach or default of the take- and-pay contract each time such failure occurs, and it would become legally responsible toward the seller for damages upon the occurrence of every such breach or default. The buyer doesn’t have the right to refuse to take the settled quantity and then make a year-end take-or-pay payment, and also, the buyer doesn’t become entitled towards receiving make-up at a later date for any quantity that it has not taken.
The damages accessible to the seller when the buyer fails to take the delivery of the commodity might be like unspecified general damages, or they might contain stipulated liquidated damages, but in many cases, they would not be the full contract price for the untaken quantity.
The main distinguishing feature in a take-and-pay contract is that every failure by the buyer to take the minimum contract quantity is a separate violation of contract for which the seller should bring a corresponding damages to claim, and in case the buyer actively resists the sellers claim it might be a long period of time before the seller is capable of recovering its damages. Unless the contract covers a provision for liquidated damages, then this kind of breach, in seeking recovery for such breach the seller would be required, amongst other things, to show proof of its actual loss and evidence of its efforts to alleviate such loss. All of this would typically need considerable time to pursue.
A take-and-pay contract is governed by U.S. law and to which Article 2 of the Uniform Commercial Code (UCC)(1) is applicable where the seller might also be able to avail itself of its adequate assurances rights upon a violation or default by the buyer. In such an event, the seller might be entitled to suspend further performance of the contract until it has acquired suitable assurances from the buyer.
A Take or pay is a contract that obligates one individual to either take possession of certain products or pay a certain amount. This contract ensures that a transaction takes place and that the individual supplying the product or service is not left in a helpless situation. They are most familiar in the energy industry, where the providers of natural gas, as well as other suppliers, consent to buy fuel or pay an amount to walk away.