isda credit protections: tools to mitigate your company’s risks napco conference may 4, 2012 kevin...

ISDA Credit Protections: Tools to Mitigate Your Company’s Risks

NAPCO Conference

May 4, 2012

Kevin M. Page

Jackson Walker L.L.P.

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Overview of Topics• Key Credit Provisions in the ISDA Master Agreement:

– Credit Support Default– Cross Default– Credit Event Upon Merger– Setoff

• ISDA Credit Support Annex

• Other Credit Tools Utilized with the ISDA– Adequate Assurance of Performance– Downgrade Event– Guaranties– Letters of Credit– First Liens

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Credit Support Default – §5(a)(iii)

• Credit Support Default:

– Event of Default under the ISDA

– Definition: • Failure to comply with or perform Credit Support Document after the lapse of

any grace period therein;

• Expiration or termination of a Credit Support Document prior to the satisfaction of all obligations of such party under each Transaction to which such Credit Support Document relates without the written consent of the other party; or

• A party or Credit Support Provider repudiates, rejects or disclaims, in whole or part, the validity of a Credit Support Document.

• 2002 ISDA Master Agreement - includes the failure of a security interest granted by a Credit Support Document

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Credit Support Document

• Credit Support Document

– Definition: a document that secures a party’s obligations under the ISDA Agreement.

– Must be specified in Part 4(f) of the ISDA Schedule.

– The most common Credit Support Document utilized in commodity trading agreements is the guaranty.

– If the ISDA is secured by a lien, a Credit Support Document may include the security agreement, deed of trust, or other documents by which the lien is granted.

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Credit Support Provider

• Credit Support Provider:– Definition: Generally any party that delivers or issues a “Credit

Support Document” on behalf of a party that secures the ISDA obligations of such party.

– Must be specified in Part 4(g) of the ISDA Schedule.

– The most common Credit Support Provider is a guarantor.

– A Credit Support Provider may be a related party entering into a document to provide security for ISDA obligations (whether in the form of a guaranty, security agreement, mortgage, etc.).

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Cross Default – §5(a)(vi)• Cross Default: Two Scenarios

1. A default (however described) under one or more agreements relating to Specified Indebtedness in an aggregate amount of not less than the Threshold Amount (specified in the Schedule) which results in such Specified Indebtedness becoming (or becoming capable at such time of being declared) due and payable before it otherwise would have been due and payable; or

2. A default in making one or more payments under agreements relating to Specified Indebtedness on the due date in an aggregate amount not less than the Threshold Amount (after any applicable notice or grace period under such agreements).

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Cross Default – §5(a)(vi)

• Scenario 1 – Three Issues:

1. What is Specified Indebtedness?

2. What is the Threshold Amount?

3. Does cross default or cross acceleration apply?

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• Specified Indebtedness:

– Defined in Section 14 of the Master Agreement.

– Generally any “indebtedness for borrowed money.”

– May be modified in Part 1 of the Schedule:

• In an interest rate swap or first lien credit facility, “Specified Indebtedness” is usually tied to the underlying credit agreement or loan documents.

• Bank counterparties may exclude depository obligations from the definition of “Specified Indebtedness”

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• Threshold Amount:

– Sets the level of materiality for a Cross Default

– Flat v. Floating Threshold Amount:

• Flat Threshold Amount provides certainty, but does not shift as a party’s creditworthiness changes

– Example: $20 million

• Floating Threshold Amount can be difficult to ascertain, but is common with banks and other financial entities

– Example: 3% of shareholders’ equity

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• Cross Default v. Cross Acceleration:

– Cross Default:

A default on Specified Indebtedness over the Threshold Amount results in such Specified Indebtedness becoming (or becoming capable at such time of being declared) due and payable before it otherwise would have been due and payable.

– Cross Acceleration:

• In the Schedule, the parties delete the parenthetical “(or becoming capable at such time of being declared)”.

• Result? Specified Indebtedness must be accelerated before an Event of Default arises under the ISDA.

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Cross Default – §5(a)(vi)• Scenario 2:

– Only relates to the amount of a payment default under Specified Indebtedness—not the principal amount of Specified Indebtedness as a whole.

– Key: whether the amount of the payment default exceeds the Threshold Amount.

• Scope of Cross Default: Relates to an ISDA party, a Credit Support Provider or a Specified Entity designated in the Schedule.

– Specified Entities might include affiliates that are not guaranteeing ISDA obligations, but whose default could impact the ISDA party’s performance.

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Credit Event Upon Merger – §5(b)(iv)

• Credit Event Upon Merger:

– A party, its Credit Support Provider or a Specified Entity of such party merges with, or transfers all or substantially all of its assets to, another entity; AND

– The creditworthiness of the resulting or surviving entity is “materially weaker” than that of the transferring party (as measured immediately prior to such action).

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Credit Event Upon Merger – §5(b)(iv)

• Credit Event Upon Merger (cont.):

– Must be affirmatively elected in the Schedule as applicable.

– Some parties prefer to define “materially weaker” in the Schedule:

• Ratings trigger

• Financial ratios

– If “materially weaker” is not defined, a non-defaulting party has flexibility in determining whether a Credit Event Upon Merger has occurred.

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Setoff Rights 1992 ISDA: No setoff provision

If included, added to the Schedule in Part 5

2002 ISDA: Setoff provision in §6(f)

Non-defaulting Party may setoff the Early Termination Amount against any other amounts owed between the parties under the ISDA or other agreements.

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Setoff Rights Types of Setoff:

Bilateral Setoff only applies to amounts owed between the ISDA parties § 6(f) of 2002 ISDA is a bilateral setoff provision.

Triangular Includes Affiliates of one of the ISDA parties. Oct. 2011: UBS decision in the Lehman bankruptcy – ISDA

triangular setoff provision was not enforceable.

Rectangular Both parties and Affiliates of both parties. Not enforceable.

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Party A$50,000

$25,000

Party B: Files for bankruptcy

Party A: Terminates TransactionsLiquidates Transactions

Setoff Rights: BilateralMMBtu

Party B

Result With Bilateral Setoff:

Party A pays Party B $25,000

Party B pays Party A $-0-

Result Without Bilateral Setoff:


Party B pays Party A $25,000 in bankruptcy dollars

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Power

MMBtu$50,000

$25,000

Party B files for bankruptcy

Party A:Terminates Transactions

Liquidates Transactions

Party A Party B

Party A Affiliate

$55,000

Power$40,000

Party B owes to Party A and Party A Affiliate:

MMBtu $25,000Power $55,000

$80,000

Party A and Party A Affiliate owe to Party B:

MMBtu $50,000Power $40,000

$90,000

Setoff Rights: Triangular

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Power

MMBtu$50,000

$25,000

Party A Party B

Party A Affiliate

$55,000

Power$40,000

Setoff Rights: Triangular

Result with Triangular Setoff:

Party A and Party A Affiliate pay Party B $10,000

Party B pays Party A and Party A Affiliate $-0-

Result without Triangular Setoff:


Party A Affiliate pays Party B $40,000

Party B pays Party A $80,000 in bankruptcy dollars

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Derivatives

MMBtu$50,000$25,000

Party B: Files for bankruptcy

Party A: - Terminates Transactions

- Liquidates Transactions

Party A Party B

Party BAffiliate

$55,000

Power$40,000

Party A and Party A Affiliate owe to Party B and Party B Affiliate:

MMBTU: $50,000Power: $45,000

$95,000

Party AAffiliate Power $5,000

Derivatives $7,000

Setoff Rights: Rectangular

Party B and Party B Affiliate owe to Party A and Party A Affiliate:

MMBTU: $25,000Derivatives: $62,000

$87,000

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Derivatives

MMBtu$50,000$25,000

Party A Party B

Party BAffiliate

$55,000

Power$40,000Party AAffiliate Power $5,000

Derivatives $7,000

Setoff Rights: Rectangular

Result with Rectangular Setoff:

Party A and Party A Affiliate pay Party B and Party B Affiliate $8,000

Party B and Party B Affiliate pay Party A and Party A Affiliate $-0-

Result without Rectangular Setoff:

Party A pays Party B $50,000Party A Affiliate pays Party B $5,000Party B pays Party A $80,000 in bankruptcy dollarsParty A pays Party B Affiliate $40,000Party B Affiliate pays Party A Affiliate $7,000

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Setoff Rights Why is Setoff Important? Safe Harbor Rights:

“Swap Agreements”: 11 U.S.C. §101(25)

“Forward Contracts”: 11 U.S.C. §101(53B)

Notwithstanding the automatic stay following a bankruptcy filing, the ISDA parties can:

Terminate the ISDA Liquidate all transactions under the ISDA Exercise setoff rights and make the termination payment

Such rights must be permitted in the underlying contract. Defense to constructive fraudulent transfer claims.

Benefit: Avoids entanglement with bankruptcy proceedings and avoids market risk while the case proceeds.

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Credit Support Annex

• Paragraph 2: Security Interest in Posted Collateral• Each Pledgor grants a first priority continuing

security interest, lien on, and right of Set-Off against all Posted Collateral.

• When Posted Collateral is returned to the Pledgor, the security interest and lien are released immediately without further action.

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Credit Support Annex• Security Interest in Posted Collateral:

• Only applies to “Posted Collateral”—not “Posted Credit Support”.

• “Eligible Collateral” that is posted with a Secured Party is called “Posted Collateral”.

• Most common Eligible Collateral elected in Paragraph 13 is Cash.

• Security interest would not apply to other forms of credit support, such as Letters of Credit.

• Primarily aimed at financial institutions which may use Treasuries, bonds, equities or other assets as collateral.

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Credit Support Annex• Paragraph 3(a): Delivery Amount. Upon a demand

by the Secured Party:

• If on any Valuation Date the Delivery Amount equals or exceeds the Pledgor’s Minimum Transfer Amount, then

• The Pledgor Transfers Eligible Credit Support with a Value at least equal to the Delivery Amount.

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Credit Support Annex• Paragraph 3(a): Delivery Amount (cont.):

• Delivery Amount: the amount by which the Credit Support Amount exceeds the Value of all Posted Credit Support held by the Secured Party.

• What is the Credit Support Amount?

• Does it exceed the Value of all Posted Credit Support (e.g., Cash, Letters of Credit, etc.) currently held by the Secured Party?

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• Credit Support Amount:

• Secured Party’s Exposure, plus

• Pledgor’s Independent Amount, minus

• Secured Party’s Independent Amount, minus

• The Pledgor’s Threshold; provided if such value is negative, the Credit Support Amount is zero (0).

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• Exposure:

• Defined in Paragraph 12 of CSA

• The amount payable under Section 6(e)(ii) of the ISDA Master Agreement as if all Transactions terminated as of the Valuation Date.

• Takes into account all forward mark-to-market positions and amounts owing between the parties.

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• Independent Amount

• Elected by the parties in Paragraph 13

• Collateral “cushion” required to be maintained by Pledgor in addition to any other Delivery Amount.

• Represents the amount by which the party posting an Independent Amount over-collateralizes its obligations.

• Threshold

• Threshold for each party is stated in Paragraph 13.

• Most often credit ratings matrix that varies by counterparty.

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Credit Support Annex• Paragraph 3(a): Delivery Amount (cont.): Once you

calculate any Delivery Amount, does it exceed the Pledgor’s Minimum Transfer Amount?

• Minimum Transfer Amount:

• Credit evaluation that varies by counterparty and the anticipated volume of Transactions under the ISDA.

• Designated by the parties in Paragraph 13.

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Credit Support Annex• Paragraph 3(b): Return Amount. Upon a demand by

the Pledgor:

• If on any Valuation Date the Return Amount equals or exceeds the Secured Party’s Minimum Transfer Amount, then

• The Secured Party Transfers Posted Credit Support with a Value at least equal to the Return Amount.

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Credit Support Annex• Paragraph 3(b): Return Amount (cont.):

• Return Amount: The Value of all Posted Credit Support held by the Secured Party, minus the Credit Support Amount.

• What is the Value of all Posted Credit Support (e.g., Cash, Letters of Credit, etc.) held by the Secured Party?

• Does it exceed the Credit Support Amount?

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Credit Support Annex• Paragraph 4(a): Conditions Precedent. Each

obligation to Transfer amounts under Paragraphs 3 (Delivery/Return Amounts) and 5 (Dispute Resolution) is subject to the condition precedent that:

• No Event of Default, Potential Event of Default or Specified Condition has occurred and is continuing with respect to the other party; and

• No Early Termination Date for which unsatisfied payment obligations exist has occurred or been designated under the Agreement.

• Caution: Ipso Facto

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Credit Support Annex• Paragraph 4(b): Transfer Timing.

• If a demand is made by the Notification Time, then Transfers are made no later than close of business on the next Local Business Day.

• If a demand is made after the Notification Time, Transfers are made no later than the second Local Business Day.

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Credit Support Annex• Paragraph 4(b): Transfer Timing (cont.)

• Notification Time elected by the parties in Paragraph 13 (e.g., 1:00 p.m. EST on any Local Business Day).

• No distinction between various types of Eligible Credit Support elected in Paragraph 13, including Letters of Credit.

• Operational Concerns: While Cash may be Transferred quickly, what about LOC issuances and amendments?

• Does your company need to increase Transfer timing to avoid breach?

• If you are receiving the collateral, how long can you afford to wait before receiving it?

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Credit Support Annex• Paragraph 6(c): Use of Posted Collateral.

• If the Secured Party is not a Defaulting Party or an Affected Party and no Early Termination Date has occurred, then the Secured Party has the right to sell, invest, assign, commingle or otherwise dispose of any Posted Collateral.

• However, the Secured Party shall be deemed to be holding such Posted Collateral for purposes of calculating Delivery/Return Amounts and Disputed Amounts.

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Credit Support Annex• Paragraph 6(c): Use of Posted Collateral.

• Rehypothecation of cash is an important right.

• Post-financial crisis, some parties may limit the ability to rehypothecate cash and instead require that cash be held in a segregated collateral account.

• Rehypothecation is a significant benefit to the Secured Party and causes some to only accept cash.

• If rehypothecation is not acceptable to a posting party, easiest remedy is to post only letters of credit.

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Credit Support Annex• Paragraph 7: Events of Default:

• A party (or its Custodian) fails to Transfer Eligible Collateral, Posted Collateral or an Interest Amount when required if not cured within 2 Local Business Days after receiving notice of same.

• A party fails to comply with Paragraph 6(c) (“Use of Posted Collateral”) if not cured within 5 Local Business Days after receiving notice of same.

• A party fails to comply with any other obligation under the Annex (not otherwise a separate Event of Default) if not cured within 30 days after receiving notice of such failure.

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Credit Support Annex• Paragraph 7: Events of Default: Any default under

Paragraph 7 of the CSA is an Event of Default under Section 5(a)(iii) of the Master Agreement:

• Right to suspend payments and performance under Section 2(a)(iii) of the Master Agreement.

• Right to suspend Transfers of Eligible Credit Support under Paragraph 4(a) of the CSA.

• Right to designate an Early Termination Date and liquidate all Transactions under the ISDA.

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Credit Support AnnexParagraph 8(a): Secured Party’s Rights and Remedies.

• When do Secured Party’s rights arise?

• Event of Default as to Pledgor

• Specified Condition as to Pledgor, or

• Practice Note: “Specified Conditions” are Termination Events elected by the parties in Paragraph 13.

• The occurrence or designation of an Early Termination Date with respect to the Pledgor

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Paragraph 8(a): Secured Party’s Rights and Remedies.

• What rights are available? Unless Pledgor has paid all Obligations then due, Secured Party may exercise any of the following remedies:• All remedies available under applicable law;

• Any rights and remedies under Other Posted Support• E.g., Drawing on outstanding Letters of Credit

• Setoff of amounts payable by Pledgor against Posted Collateral held by Secured Party; or

• Liquidate Posted Collateral and apply proceeds to any Obligations owed by Pledgor.

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Paragraph 8(b): Pledgor’s Rights and Remedies.

• When do Pledgor’s rights arise?

• The occurrence or designation of an Early Termination Date arising from an Event of Default or Specified Condition with respect to the Secured Party.

• Practice Note: Pledgor’s rights do not arise until the occurrence or designation of an Early Termination Date—not merely upon the occurrence of an Event of Default or Specified Condition.

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• What rights are available? Unless Secured Party has paid all Obligations then due, the following shall apply:• Pledgor can exercise all remedies available under applicable

law.

• Pledgor can exercise any rights and remedies under Other Posted Support.

• E.g., Drawing on outstanding Letters of Credit

• Secured Party is obligated to immediately Transfer all Posted Collateral back to the Pledgor.

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• If Secured Party does not Transfer back all Posted Collateral to Pledgor, then Pledgor may:

• Set-Off amounts payable by Pledgor against any Posted Collateral held by the Secured Party; and

• If amounts are not Set-Off, withhold payment of amounts due up to the Value of Posted Collateral until such Posted Collateral is returned.

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Paragraph 13 Elections & Variables

• 13(b)(ii): Eligible Collateral.• Paragraph 13 permits the parties to specify which forms

of collateral shall constitute “Eligible Collateral” under the Annex, as well as the applicable Valuation Percentage used in determining the Value of such collateral.

• Practice Note:• Most energy commodity counterparties elect for Cash to

qualify as Eligible Collateral, but do not elect for Treasury Bills, Notes or Bonds.

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• 13(b)(iii): Other Eligible Support. • Paragraph 13 permits the parties to specify what

collateral may constitute “Other Eligible Support” apart from any Eligible Collateral.

• Practice Note:• Many parties elect for Letters of Credit to constitute

“Other Eligible Support” and provide that the Valuation Percentage shall be 100% unless (i) an Event of Default occurs and is continuing, or (ii) fewer than 20 days remain before expiry of the Letter of Credit, in which case the Valuation Percentage shall be zero (0).

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• 13(b)(iv)(C): “Minimum Transfer Amount”: A Delivery Amount must equal or exceed a Pledgor’s Minimum Transfer Amount before the Pledgor is required to Transfer collateral.

• 13(b)(iv)(D): “Rounding”: The parties may specify the dollar amount by which calculated values will be rounded up or down.

MTA and RA Delivery Amount: Rounded To: Required to Post:

$0 / $100,000 $35,000 $100,000 $100,000

$0 / $1 $35,000 $35,000 $35,000

$100,000 / $1 $35,000 $35,000 $0

$100,000 / $100,000

$35,000 $100,000 $100,000

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• 13(d): Conditions Precedent and Secured Party’s Rights and Remedies.

• “Specified Conditions” – Certain Termination Events elected by the parties under Paragraphs 8(a) and 8(b).

• Because Specified Conditions give rise to collateral rights, each party may have different preferred Specified Conditions.

• E.g., Credit Event Upon Merger

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• 13(j): Other Eligible Support and Other Posted Support.

• Paragraph 13 permits the parties to define how to calculate the “Value” of Other Eligible Support and Other Posted Support, as well as what constitutes a “Transfer” of same.

• Refers to collateral other than cash, so it may be beneficial to designate how such collateral is valued and transferred under the Annex.

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• 13(j): Other Eligible Support and Other Posted Support.

• Examples:

• Will the Value of the Letter of Credit decrease if certain conditions exist (e.g., the Letter of Credit expires within 20 days or a default exists)?

• Will “Transfers” include increasing/decreasing the stated value of an existing Letter of Credit?

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• 13(m): Other Provisions. The parties may incorporate additional credit terms and conditions that apply to the CSA.

• Additional definitions:

• E.g., “Letter of Credit”, “Qualified Institution”, “Credit Rating”.

• Changes to Transfer timing:

• E.g., Increasing the time for Pledgor to issue or amend a Letter of Credit.

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Other Credit ToolsUtilized with the ISDA

• Adequate Assurance of Performance

• Downgrade Event

• Guaranties

• Letters of Credit

• First Liens

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Adequate Assurance of Performance Trigger - If either party has reasonable grounds for

insecurity regarding the performance of the other party under the ISDA.

“Adequate Assurance of Performance”: generally cash and letters of credit.

Added in the Schedule as an Additional Event of Default, Additional Termination Event or miscellaneous provision.

The amount that may be requested is usually any amount reasonably determined by the Secured Party.

Used when the deal does not warrant a CSA (e.g., short term or tenor) or the parties are not set up for daily margining.

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Downgrade Event Downgrade Event - The credit rating of a party or

its Credit Support Provider falls below a stated credit rating threshold.

Remedies – Usually either termination of the ISDA or additional collateral.

Varies depending on the risk tolerance of the non-downgraded party.

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Downgrade Event Downgrade Events are usually Additional Events

of Default or Additional Termination Events:

Additional Event of Default: Non-Defaulting Party calculates damages All Transactions must terminate Right to terminate arises immediately

Additional Termination Event: Either party could be an “Affected Party” If 2 Affected Parties, both calculate damages Only Affected Transactions terminate Right to terminate may not arise immediately

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Guaranties Third party (usually parent) agrees to pay

Guarantee of payment not performance

Enhances counterparty’s creditworthiness

Guarantor’s right of subrogation

Termination only releases Guarantor from future liability – not prior payment obligations

“Credit Support Document” in the ISDA Schedule.

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Guaranties

BEFORE TERMINATION

Guaranty

Letter of Credit Termination

Credit Protection: Guaranties v. Letters of Credit

AT AND AFTER TERMINATION

Guaranty

Letter of Credit Termination

Protected

Not Protected

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Guaranties When are Guaranties used?

A party has: Little or no creditworthiness;

Limited liquid collateral; and

An affiliate with creditworthiness

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Guaranties Advantages:

Liquid (but see next slide)

Simple

Common

Generally quick to negotiate and implement

For beneficiaries, potentially adds value if Guarantor and subsidiary go bankrupt Ex: Enron corporate guaranty roughly doubled

unsecured creditors’ recovery

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Guaranties Disadvantages:

Contract obligation, not cash or property

Guarantor’s creditworthiness may subsequently deteriorate

Guarantor is required to report guaranteed obligations on its financial statements

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Guaranties Defenses to Payment:

Generally, Guarantor has same defenses as Counterparty under trading agreement Exceptions:

Non-payment because of discharge of counterparty’s obligations in bankruptcy

Non-payment because counterparty lacked capacity under the agreement

Any defenses expressly waived in guaranty

Suretyship defenses

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Letters of Credit Financial institution agrees to pay up to the

value of the letter of credit

Second only to cash

Generally short-term in nature Common term is 30 days to 1 year

Listed as “Other Eligible Support” in the ISDA Credit Support Annex.

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Letters of Credit Party posting the letter of credit is usually

responsible for all related fees

Fees Associated with Letters of Credit Monthly fee to maintain the credit facility, whether

or not letter of credit is issued Usually a percentage of total amount available under

letter of credit facility

Fee when letter of credit is actually issued

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Letters of Credit

Common Limitations Imposed by Issuer: Maximum number of letters of credit

Maximum amount outstanding

Approval of beneficiary

Approval of form

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Letters of Credit Drawing on a Letter of Credit:

Administrative Obstacles Compliance with drawing conditions

May require an officer of the beneficiary to present the draw request to the issuer.

Default under agreement generally must be continuing May be required to present certified statement of default

Physical presentation of letter of credit to issuing bank Ability (or inability) to make partial and/or multiple

withdrawals Depends on express terms in letter of credit

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Letters of Credit

Multiple and partial withdrawals are preferred

If not allowed, then: Beneficiary may draw on letter of credit only one

time

Wait until the maximum amount allowed under the letter of credit is owed before drawing on the letter of credit

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Letters of Credit Advantages:

Liquid

Simple

Commonly used

Disadvantages: For beneficiaries, risk that issuer will become insolvent

For issuers, payment risk if called upon to perform under letter of credit

For posting party, risk of expenses to replace if called upon

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First Liens General Overview

Debtor under an existing credit facility has provided a first lien and security interest in a tangible asset to lenders

Debtor enters into trading agreements with hedge counterparties relating to the asset, and offers first lien as collateral Ex: Debtor enters into ISDA with Gas Annex in order to

purchase fuel for electric generation facility

Hedge counterparty holds first priority lien and security interest pari passu with lenders

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First Liens General Overview (cont.)

Lenders willing to share first lien because trading relationship with hedge counterparty: Reduces risk

Ex: If hedge counterparty sells natural gas to run debtor’s power plant, reduces the risk that the plant will be unable to produce electricity

Increases value of the asset Ex: If debtor sells a power plant’s electricity to hedge

counterparty, this mitigates the risk of not finding a purchaser for the plant’s output or that power prices may decline over time.

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First Liens Documents in First Lien Structures

Loan Documents: May impact a hedge counterparty’s rights in relation to other lenders Credit Agreement

Intercreditor Agreement

Security Agreement or Collateral Trust Agreement

Designation and Joinder Agreement

Trading Documents: Between hedge counterparty and debtor First lien protections often documented under an ISDA, but can

be incorporated into NAESB or EEI

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First Liens

3 Types of First Lien Credit Structures Replacement Structure

Threshold Structure

Tail Risk Structure

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First Liens

Replacement Structure First lien wholly replaces any other collateral obligations of

debtor under the trading agreement

Debtor not required to provide any cash, letter of credit or guaranty

Cheaper to implement than other forms of credit support

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First Liens

Threshold Structure Hedge counterparty assigns a value to the first lien

Such value establishes a fixed collateral threshold for debtor under the trading agreement

Debtor only provides alternative forms of collateral if hedge counterparty’s exposure exceeds the threshold

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First Liens

Tail Risk Structure Debtor initially posts collateral to hedge counterparty up to a

fixed amount

The First Lien covers debtor’s “tail risk” over and above the credit limit Debtor’s collateral obligations are fixed despite any subsequent

market fluctuations altering hedge counterparty’s exposure.

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First Liens Debtor’s Order of Preference for First Lien

Structures Replacement Structure

Debtor provides no collateral except the First Lien

Tail Risk Structure Debtor’s collateral obligations are fixed up to a certain amount, and

the First Lien covers all other hedge counterparty exposure

Threshold Structure Debtor still receives value for its First Lien, but may have to post

additional collateral depending on hedge counterparty’s exposure

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First Liens Counterparty’s Order of Preference for First Lien

Structures Threshold Structure

Accounts for the value of debtor’s first lien, but also protects against market risk by requiring additional collateral

Tail Risk Structure Hedge counterparty initially receives collateral as security, and

enjoys the benefits of First Lien protection

Replacement Structure Risk that hedge counterparty’s exposure will exceed the value of the

First Lien, and no other collateral available

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First Liens Advantages to Debtor

No additional collateral needed

No liquidity needed

More equity may be available under Credit Agreement than in other credit structures

Lower administrative burden

More efficient use of the capital locked up in the assets of the first lien estate

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First Liens Advantages to Counterparty

Right in tangible asset rather than contractual interest

Aligned interests with lender

“Right-way risk” As the price of input or product increases (thus

potentially increasing a hedge counterparty’s exposure), the value of the asset on which counterparty holds a first lien also increases.

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First Liens Disadvantages to Debtor

Counterparty still may demand additional collateral or price concessions

Low asset valuation for credit purposes First liens are fairly illiquid and contingent upon terms

of a Credit Agreement or actions by lenders

Requires positive multiple of equity to debt on assets in facility

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First Liens Disadvantages to Debtor (cont.)

First lien places hard assets at risk that are not otherwise affected in other credit structures

Even if counterparty accepts first lien, counterparty may impose conservative risk limits and parameters in the transactions secured by the first lien Impacts ability to trade with hedge counterparty

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First Liens Disadvantages to Counterparty

Highly illiquid collateral

Extended delay between default and payment

Lack of control in collateral Acting as part of a group of creditors rather than

individually

Risk if counterparty’s interests diverge from other lenders and hedge counterparties

Not fungible

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First Liens Additional Considerations with First Liens

Voting Rights Generally contained in the Credit Agreement

Matters on which hedge counterparty can vote (and weight of vote) often differ from lenders

Ratio of (i) exposure to debtor, compared to (ii) cumulative debt under credit facility

Compared to lenders in the credit facility, hedge counterparty may have little or no voting power

Hedge counterparties must work with lenders because interests are linked

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First Liens Additional Considerations with First Liens

Payment of Debt Hedge counterparty’s collateral rights stem from Credit

Agreement When Credit Agreement is paid in full or terminated,

hedge counterparty must ensure that it will be covered Can the lenders release the lien without the hedge

counterparty’s consent? Can the lenders release the lien without the debtor providing

alternative forms of collateral?

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First Liens First Lien Terms in the ISDA:

Events of Default / Termination Events Debtor’s obligations cease to be subject to first lien

Hedge Counterparty’s right to payment ceases to be pari passu with lenders

Value of estate drops below a specified level

Threshold Threshold, Replacement or Tail Risk Structure?

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First Liens First Lien Terms in the ISDA (cont.):

Representations, Warranties & Covenants Debtor’s authorization to provide the First Lien under

the Credit Agreement

Compliance with representations in the Credit Agreement

Transfer and Assignment Align ISDA with Credit Agreement

Ex: Can the ISDA be assigned or encumbered?

85

Conclusion While the ISDA provides various “standard”

credit provisions, credit risk must be tailored to each transaction.

Credit risk is not absolute, but exists on a continuum.

Different points on the continuum require different risk mitigants

86

Conclusion

Risk levels are influenced by many factors: Nominal deal value Tenor of the deal Market liquidity and Relative creditworthiness of counterparty

RISKLOW HIGH

Next-Day Index Gas Sale Long-Term Tolling Arrangement

Guaranty? First Lien or Margining?Letter of Credit?

87

Conclusion

The key is to identify:

Where your specific transaction falls on the risk continuum

Whether the standard ISDA offers sufficient credit protection, or whether additional credit tools are needed.

RISKLOW HIGH

Next-Day Index Gas Sale Long-Term Tolling Arrangement

Guaranty? First Lien or Margining?Letter of Credit?

88

Conclusion

COST &

TIME

CREDIT RISK MITIGATION

Low High

Guaranty

First Lien

89

QUESTIONS?

Kevin M. [email protected](713) 752-4227

Jackson Walker L.L.P.1401 McKinney, Suite 1900

Houston, Texas 77010

mailto:[email protected]