ISDA Credit Protections: Tools to
Mitigate Your Company’s Risks
NAPCO Conference
May 4, 2012
Kevin M. Page
Jackson Walker L.L.P.
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
2
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
3
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.
4
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.).
5
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).
6
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?
7
Cross Default – §5(a)(vi)
•
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”
8
Cross Default – §5(a)(vi)
•
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
9
Cross Default – §5(a)(vi)
•
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.
10
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.
11
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).
12
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.
13
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.
14
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.
15
Setoff Rights: Bilateral
MMBtu
$50,000
Party A
$25,000
Party B
Party B:
Files for bankruptcy
Party A:
Terminates Transactions
Liquidates Transactions
Result With Bilateral Setoff:
Result Without Bilateral Setoff:
Party A pays Party B $25,000
Party A pays Party B $50,000
Party B pays Party A $-0-
Party B pays Party A $25,000 in
bankruptcy dollars
16
Setoff Rights: Triangular
Power
$55,000
Party A
MMBtu
$50,000
Party B
$25,000
Power
$40,000
Party A Affiliate
Party A and Party A
Affiliate owe to Party B:
Party B owes to Party A and
Party A Affiliate:
MMBtu
Power
MMBtu
Power
$50,000
$40,000
$90,000
$25,000
$55,000
$80,000
Party B files for bankruptcy
Party A:
Terminates Transactions
Liquidates Transactions
17
Setoff Rights: Triangular
Power
$55,000
Party A
MMBtu
$50,000
Party B
$25,000
Power
$40,000
Party A Affiliate
Result with Triangular Setoff:
Result without Triangular Setoff:
Party A and Party A Affiliate pay
Party B $10,000
Party A pays Party B $50,000
Party B pays Party A and Party A
Affiliate $-0-
Party A Affiliate pays Party B $40,000
Party B pays Party A $80,000 in
bankruptcy dollars
18
Setoff Rights: Rectangular
Derivatives
$55,000
MMBtu
$50,000
$25,000
Party A
Party B
Derivatives
$7,000
Party B
Affiliate
Party A
Affiliate
Party A and Party A
Affiliate owe to Party B
and Party B Affiliate:
MMBTU: $50,000
Power:
$45,000
$95,000
Party B and Party B
Affiliate owe to Party A
and Party A Affiliate:
MMBTU: $25,000
Derivatives: $62,000
$87,000
Party B: Files for
bankruptcy
Party A:
- Terminates Transactions
- Liquidates Transactions
19
Setoff Rights: Rectangular
Derivatives
$55,000
MMBtu
$50,000
$25,000
Party A
Party B
Derivatives
$7,000
Party A
Affiliate
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-
Party B
Affiliate
Result without Rectangular Setoff:
Party A pays Party B $50,000
Party A Affiliate pays Party B $5,000
Party B pays Party A $80,000 in bankruptcy
dollars
Party A pays Party B Affiliate $40,000
Party B Affiliate pays Party A Affiliate $7,000
20
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.
21
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.
22
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.
23
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.
24
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?
25
Credit Support Annex
• Paragraph 3(a): Delivery Amount (cont.):
• 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).
26
Credit Support Annex
• Paragraph 3(a): Delivery Amount (cont.):
• 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.
27
Credit Support Annex
• Paragraph 3(a): Delivery Amount (cont.):
• 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.
28
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.
29
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.
30
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?
31
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
32
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.
33
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?
34
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.
35
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.
36
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.
37
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.
38
Credit Support Annex
Paragraph 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
39
Credit Support Annex
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.
40
Credit Support Annex
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.
41
Credit Support Annex
Paragraph 8(b): Pledgor’s Rights and Remedies.
• 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.
42
Credit Support Annex
Paragraph 8(b): Pledgor’s Rights and Remedies.
•
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.
43
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.
44
Paragraph 13 Elections & Variables
• 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).
45
Paragraph 13 Elections & Variables
• 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
46
Paragraph 13 Elections & Variables
• 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
47
Paragraph 13 Elections & Variables
• 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.
48
Paragraph 13 Elections & Variables
• 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?
49
Paragraph 13 Elections & Variables
• 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.
50
Other Credit Tools
Utilized with the ISDA
•
•
•
•
•
Adequate Assurance of Performance
Downgrade Event
Guaranties
Letters of Credit
First Liens
51
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.
52
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 nondowngraded party.
53
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
54
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.
55
Guaranties
Credit Protection: Guaranties v. Letters of Credit
BEFORE TERMINATION
Guaranty
Letter of Credit
Termination
AT AND AFTER TERMINATION
Guaranty
Letter of Credit
Termination
Protected
Not Protected
56
Guaranties
 When are Guaranties used?
 A party has:
 Little or no creditworthiness;
 Limited liquid collateral; and
 An affiliate with creditworthiness
57
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
58
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
59
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
60
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.
61
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
62
Letters of Credit
 Common Limitations Imposed by Issuer:
 Maximum number of letters of credit
 Maximum amount outstanding
 Approval of beneficiary
 Approval of form
63
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
64
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
65
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
66
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
67
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.
68
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
69
First Liens
 3 Types of First Lien Credit Structures
 Replacement Structure
 Threshold Structure
 Tail Risk Structure
70
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
71
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
72
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.
73
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
74
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
75
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
76
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.
77
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
78
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
79
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
80
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
81
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?
82
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?
83
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?
84
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
85
Conclusion
RISK
LOW
HIGH
Next-Day Index Gas Sale
Guaranty?
Long-Term Tolling Arrangement
Letter of Credit?
First Lien or Margining?
 Risk levels are influenced by many factors:




Nominal deal value
Tenor of the deal
Market liquidity and
Relative creditworthiness of counterparty
86
Conclusion
RISK
LOW
HIGH
Next-Day Index Gas Sale
Guaranty?
Long-Term Tolling Arrangement
Letter of Credit?
First Lien or Margining?
 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.
87
Conclusion
First Lien
COST &
TIME
Guaranty
Low
High
CREDIT RISK MITIGATION
88
QUESTIONS?
Kevin M. Page
[email protected]
(713) 752-4227
Jackson Walker L.L.P.
1401 McKinney, Suite 1900
Houston, Texas 77010
89
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