Over the past decade, the energy industry has faced significant uncertainty. From Enron Corp. through SemGroup LP and Lehman Brothers Holdings Inc., this volatility has led to several prominent energy-related bankruptcies.

Today, the industry continues to face challenges concerning economic prospects, commodity prices and interest rates. Thus, energy traders should act now to review their contingency plans for a major counterparty bankruptcy.

Long before a counterparty bankruptcy is contemplated, a trader can protect itself with contractual safeguards. First, its agreements should include numerous events of default -- not just those tied to bankruptcy. These may allow for earlier termination when bankruptcy rumors surface. Second, after a default, the contract must provide termination rights. Contracts should require segregation of collateral or mandate a prompt return of collateral if the market moves against the secured party. Finally, despite recent case law, broad setoff rights are desirable because they may still be enforceable in some courts, and they can be useful in a nonbankruptcy default.

In the weeks preceding bankruptcy, traders listen for market rumors. Once bankruptcy rumors are in the marketplace, traders should analyze their contracts' treatment of posted collateral. If collateral is not segregated, any surplus collateral becomes exposure to the counterparty. If the counterparty files bankruptcy while overcollateralized, its obligation to return excess collateral generally converts to an unsecured bankruptcy claim.

As bankruptcy nears, both parties will make key decisions -- such as delaying payments and deliveries -- based on the pending bankruptcy. Even with bankruptcy imminent, one should accept any payment that the troubled company will make, despite the risk of a later preference action. After accepting payment, many things can alter the preference risk: The company may avoid bankruptcy, its records could be lost or destroyed, or the creditor might settle with the trustee. Meanwhile, the creditor has the time value of money. Safe-harbor statutes give traders additional motivation to accept payment because they exempt many transfers under energy-trading contracts from preference liability.

Traders should also review their contracts for nonbankruptcy bases for termination, such as adequate assurances provisions, breaches of representations or credit support defaults. Sometimes, the contract's definition of "bankrupt" allows for a default based on poor financial condition, not actual bankruptcy.

After the bankruptcy filing, key decisions will turn on whether the trader is in the money or out of the money, the status of collateral and letters of credit, whether guarantors have also filed for bankruptcy and the status of physical deliveries. At the same time, contractual rights must be evaluated. Assuming a desire to terminate the contracts, traders should ensure that an event of default has occurred, and that the contracts allow for termination upon default. If so, do Bankruptcy Code's safe-harbor provisions apply? Those statutes guarantee enforcement to terminate and liquidate certain contracts, when other creditors are prohibited from taking those actions. If the provisions apply, the trader may terminate its transactions with the bankrupt counterparty -- although its rights might expire if it does not terminate promptly.

If the safe-harbor provisions do not apply, the trader will be enjoined by the automatic stay from exercising termination and setoff rights, even if those rights exist in the relevant contracts. A wrongful termination may lead to sanctions.

Before obtaining market information, companies should analyze the contracts for the specific valuation methodology, lest they get caught in protracted disputes with the debtor over value. To obtain market quotations for measuring termination damages, the trader should prepare employees to call the brokers. Preparation should include: the number of quotes to obtain; instructions to request a bid/offer quote for the same day and time for each transaction, with quotes for the actual volumes; and directions to avoid mentioning defaults or bankruptcy. Finally, the trader should analyze whether it qualifies for reclamation rights or administrative claims, each of which protects sellers of goods to an insolvent debtor.

Although one can never eliminate the stress -- or the losses incurred -- when a major counterparty files for bankruptcy, precautionary steps like those above can certainly help to minimize both.

Paul B. Turner is co-partner in charge of Sutherland Asbill & Brennan LLP's Houston office. Mark Sherrill is a member of the firm's energy and environmental practice group.