1 / 89

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

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

hamish
Download Presentation

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

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. ISDA Credit Protections: Tools to Mitigate Your Company’s Risks NAPCO Conference May 4, 2012 Kevin M. Page Jackson Walker L.L.P.

  2. 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

  3. 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

  4. 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.

  5. 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.).

  6. 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).

  7. 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?

  8. 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”

  9. 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

  10. 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.

  11. 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.

  12. 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).

  13. 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.

  14. 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.

  15. 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.

  16. Setoff Rights: Bilateral MMBtu Party A $50,000 Party B $25,000 Party B: Files for bankruptcy Party A: Terminates Transactions Liquidates Transactions Result With Bilateral Setoff: Party A pays Party B $25,000 Party B pays Party A $-0- Result Without Bilateral Setoff: Party A pays Party B $50,000 Party B pays Party A $25,000 in bankruptcy dollars

  17. Setoff Rights: Triangular Power $55,000 Party A Party B MMBtu $50,000 $25,000 Power$40,000 Party A Affiliate Party A and Party A Affiliate owe to Party B: MMBtu $50,000Power $40,000 $90,000 Party B owes to Party A and Party A Affiliate: MMBtu $25,000Power $55,000 $80,000 Party B files for bankruptcy Party A:Terminates Transactions Liquidates Transactions

  18. Setoff Rights: Triangular Power $55,000 Party A Party B MMBtu $50,000 $25,000 Power$40,000 Party A Affiliate 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 pays Party B $50,000 Party A Affiliate pays Party B $40,000 Party B pays Party A $80,000 in bankruptcy dollars

  19. Setoff Rights: Rectangular Derivatives Party A $55,000 Party B MMBtu $50,000 $25,000 Derivatives $7,000 Party AAffiliate Party BAffiliate Power$40,000 Power $5,000 Party A and Party A Affiliate owe to Party B and Party B Affiliate: MMBTU: $50,000Power: $45,000 $95,000 Party B and Party B Affiliate owe to Party A and Party A Affiliate: MMBTU: $25,000Derivatives: $62,000 $87,000 Party B: Files for bankruptcy Party A: - Terminates Transactions - Liquidates Transactions

  20. Setoff Rights: Rectangular Derivatives Party A $55,000 Party B MMBtu $50,000 $25,000 Derivatives $7,000 Party AAffiliate Party BAffiliate Power$40,000 Power $5,000 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

  21. 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.

  22. 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.

  23. 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.

  24. 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.

  25. 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?

  26. 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).

  27. 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.

  28. 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.

  29. 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.

  30. 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.

  31. 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?

  32. 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

  33. 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.

  34. 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?

  35. 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.

  36. 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.

  37. 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.

  38. 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.

  39. 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

  40. 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.

  41. 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.

  42. 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.

  43. 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.

  44. 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.

  45. 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).

  46. 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.

  47. 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

  48. 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.

  49. 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?

  50. 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.

More Related