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ALTERNATIVE COLLATERAL RISK MITIGATION. CRAIG R. ENOCHS Jackson Walker L.L.P. 1401 McKinney, Suite 1900 Houston, Texas 77010 JOHN LIGHTBOURN NextEra Energy Resources 700 Universe Blvd. Juno Beach, Florida 33408 International Energy Credit Association 85 th Annual Fall Conference

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ALTERNATIVE COLLATERAL RISK MITIGATION


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  1. ALTERNATIVE COLLATERAL RISK MITIGATION CRAIG R. ENOCHS Jackson Walker L.L.P. 1401 McKinney, Suite 1900 Houston, Texas 77010 JOHN LIGHTBOURN NextEra Energy Resources 700 Universe Blvd. Juno Beach, Florida 33408 International Energy Credit Association 85th Annual Fall Conference October 11-14, 2009 Orlando, Florida

  2. Credit Risk • 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

  3. Credit Risk (cont.) RISK LOW HIGH • Risk levels can be influenced by many factors, including: • Nominal deal value • Tenor of the deal • Market liquidity and • Relative creditworthiness of counterparty Next-Day Index Gas Sale Long-Term Tolling Arrangement Guaranty? Letter of Credit? First Lien or Margining?

  4. RISK LOW HIGH Next-Day Index Gas Sale Long-Term Tolling Arrangement Guaranty? Letter of Credit? First Lien or Margining? Credit Risk (cont.) • The key is to identify: • Where your specific transaction falls on the risk continuum • Which credit tool best mitigates the risks involved in the deal

  5. Credit Risk (cont.) • When selecting a credit tool, bear in mind that most credit tools merely shift risk and do not eliminate it altogether • Goal is not to eliminate risk • Rather, the goal is to meet the ideal point of intersection between credit risk and the cost and time to effect the credit tool

  6. Credit Risk (cont.) First Lien COST & TIME Guaranty Low High CREDIT RISK MITIGATION

  7. Credit Risk (cont.) • May use combination of credit tools in a transaction • Different tools may be necessary to capture: • Receivable risk v. mark-to-market risk • Independent amount v. tail risk

  8. Selected Credit Tools for Discussion • Guaranties • Letters of Credit • Prepayment • Master Netting Agreements • Master Agreements with Multiple Annexes • Credit Default Swaps • First Liens • Joint & Several Liability Agreement

  9. I. Guaranties • Third party agrees to pay • Usually parent or affiliate • 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

  10. Protected Not Protected I. Guaranties Credit Protection: Guaranties v. Letters of Credit BEFORE TERMINATION Guaranty Letter of Credit Termination AT AND AFTER TERMINATION Guaranty Letter of Credit Termination

  11. I. Guaranties (cont.) • When are Guaranties used? • A party has: • Little or no creditworthiness; • Limited liquid collateral; and • An affiliate with creditworthiness

  12. I. Guaranties (cont.) • 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

  13. I. Guaranties (cont.) • Disadvantages: • Contract obligation, not cash or property • Guarantor’s creditworthiness may subsequently deteriorate • Guarantor is required to report guaranteed obligations on its financial statements

  14. I. Guaranties (cont.) • 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

  15. II. Letters of Credit • Financial institution agrees to pay up to the value of the letter of credit • Second only to cash • Assigned higher value than less liquid or less certain forms of collateral • Generally short-term in nature • Ex: Common term is 30 days to 1 year

  16. II. Letters of Credit (cont.) • 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

  17. II. Letters of Credit (cont.) • Common Limitations Imposed by Issuer: • Maximum number of letters of credit • Maximum amount outstanding • Approval of beneficiary • Approval of form

  18. II. Letters of Credit (cont.) • Drawing on a Letter of Credit: • Administrative Obstacles • Compliance with drawing conditions • 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

  19. II. Letters of Credit (cont.) • 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

  20. II. Letters of Credit (cont.) • 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

  21. III. Prepayment • Buyer pays Seller before delivery • Net present value of sales price • Often preferred when dealing with non-creditworthy counterparties

  22. III. Prepayment (cont.) • Single v. Recurring Payment • Generally Seller prefers single payment: • Larger amount of prepayment at once • Seller is not exposed to risk if it is, in turn, purchasing long-term supply upstream • Generally Buyer prefers recurring payment: • Smaller amount of prepayment at once • Mitigates Buyer’s loss if Seller does not deliver

  23. III. Prepayment (cont.) • Single Payment Structure Example: Tax-Exempt Prepaid Transaction • Municipality issues 30-year tax-exempt bonds • Bond proceeds are used to prepay a 30-year supply of commodity at a price discounted to net present value • Municipality recovers a discount to the extent of their tax exemption

  24. III. Prepayment (cont.) • Recurring Payment Structure Example: Retail or Wholesale Prepaid Transaction • Buyer initially pays Seller’s anticipated accounts receivable for a set billing cycle (usually 60 days) • Buyer and Seller true up each month by invoice, and Buyer prepays for the following month

  25. III. Prepayment (cont.) • Recurring Payment Structure Example: Retail or Wholesale Prepaid Transaction (cont.) • Usually no mark-to-market collateralization • Best for index deals because no mark-to-market risk if either Buyer or Seller defaults

  26. III. Prepayment (cont.) • Fixed v. Variable Prepayment: • Calculation and periodic adjustments • Variable price and/or variable quantity • When using an index price, should have market disruption provisions

  27. III. Prepayment (cont.) • Liquidated Damages: • If a party is entitled to liquidated damages, Buyer’s previous prepayment to Seller directly affects: • Who pays damages; and • How payment is effectively made • Two Scenarios: • Seller fails to deliver and Buyer covers • Buyer fails to receive and Seller covers

  28. III. Prepayment (cont.) • Liquidated Damages (cont.) • If Seller Fails to Deliver and Buyer Covers: • General Rule: • Seller returns the prepayment amount to Buyer; plus • Positive difference (if any) in subtracting the contract price from Buyer’s cover price. • Seller also responsible for all Buyer’s costs and expenses in purchasing the commodity Seller failed to deliver.

  29. III. Prepayment (cont.) • Liquidated Damages (cont.) • If Seller Fails to Deliver and Buyer Covers: • Example: Buyer prepays Seller $10/MMBtu for Gas. Seller fails to deliver the Gas. • If Buyer covers at $12/MMBtu for Gas, then Seller owes: • $10/MMBtu prepayment to Buyer; plus • $2/MMBtu difference incurred by Buyer. • Seller’s $12/MMBtu payment (plus costs and expenses) keeps Buyer whole for Seller’s failure to perform.

  30. III. Prepayment (cont.) Seller Fails to Deliver and Buyer Covers at $12/MMBtu: (i) $10/MMBtu Prepayment Seller Buyer (iii) $12/MMBtu (i) Buyer prepays Seller $10/MMBtu, and Seller fails to deliver Gas (ii) Buyer covers by purchasing Gas from 3rd Party Seller at $12/MMBtu (iii) Seller pays $12/MMBtu to Buyer • $10/MMBtu original prepayment, PLUS • $2/MMBtu additional cover cost (ii) $12/MMBtu (ii) Gas 3rd Party Seller

  31. III. Prepayment (cont.) • Liquidated Damages (cont.) • If Seller Fails to Deliver and Buyer Covers: • Example: Buyer prepays Seller $10/MMBtu for Gas. Seller fails to deliver the Gas. • If Buyer covers at $5/MMBtu for Gas, then Seller owes: • $10/MMBtu prepayment to Buyer. • Seller’s breach resulted in a cost savings to Buyer (e.g., Buyer paid only $5/MMBtu instead of $10/MMBtu). • However, Seller must return Buyer’s entire prepayment and pay any additional cover costs or expenses incurred by Buyer.

  32. III. Prepayment (cont.) Seller Fails to Deliver and Buyer Covers at $5/MMBtu: (i) $10/MMBtu Prepayment Seller Buyer (iii) $10/MMBtu (i) Buyer prepays Seller $10/MMBtu, and Seller fails to deliver Gas (ii) Buyer covers by purchasing Gas from 3rd Party Seller at $5/MMBtu (iii) Seller pays $10/MMBtu to Buyer • $10/MMBtu original prepayment • Buyer keeps $5/MMBtu cost savings resulting from Seller’s breach (ii) $5/MMBtu (ii) Gas 3rd Party Seller

  33. III. Prepayment (cont.) • Liquidated Damages (cont.) • If Buyer Fails to Receive and Seller Covers: • General Rule: • Seller returns the prepayment amount to Buyer; minus • Positive difference (if any) in subtracting Seller’s resale price from the contract price. • Seller also can deduct its cover costs and expenses from the amount it returns to Buyer.

  34. III. Prepayment (cont.) • Liquidated Damages (cont.) • If Buyer Fails to Receive and Seller Covers: • Example: Buyer prepays Seller $10/MMBtu for Gas. Buyer fails to receive the Gas. • If Seller covers at $7/MMBtu for Gas, then Seller returns: • $10/MMBtu prepayment to Buyer; minus • $3/MMBtu difference incurred by Seller. • By returning only $7/MMBtu of Buyer’s original $10/MMBtu prepayment, Seller is kept whole. • Seller also can deduct any of its cover costs and expenses from the amount returned to Buyer.

  35. III. Prepayment (cont.) Buyer Fails to Receive and Seller Covers at $7/MMBtu: (i) $10/MMBtu Prepayment Seller Buyer (iii) $7/MMBtu (i) Buyer prepays Seller $10/MMBtu, and Buyer fails to receive Gas (ii) Seller covers by selling Gas to 3rd Party Buyer at $7/MMBtu (iii) Seller pays $7/MMBtu to Buyer • $10/MMBtu original prepayment, MINUS • $3/MMBtu difference between $10 contract price and $7 resale price (ii) Gas (ii) $7/MMBtu 3rd Party Buyer

  36. III. Prepayment (cont.) • Liquidated Damages (cont.) • If Buyer Fails to Receive and Seller Covers: • Example: Buyer prepays Seller $10/MMBtu for Gas. Buyer fails to receive the Gas. • If Seller covers at $12/MMBtu for Gas, then Seller returns: • $10/MMBtu prepayment to Buyer. • Seller keeps the $12/MMBtu cover payment, including the $2/MMBtu profit resulting from Buyer’s breach. • Seller can deduct any of its cover costs and expenses from the amount it returns to Buyer.

  37. III. Prepayment (cont.) Buyer Fails to Receive and Seller Covers at $12/MMBtu: (i) $10/MMBtu Prepayment Seller Buyer (iii) $10/MMBtu (i) Buyer prepays Seller $10/MMBtu, and Buyer fails to receive Gas (ii) Seller covers by selling Gas to 3rd Party Buyer at $12/MMBtu (iii) Seller pays $10/MMBtu to Buyer • $10/MMBtu original prepayment • Seller keeps $12/MMBtu cover payment, including $2/MMBtu profit (ii) Gas (ii) $12/MMBtu 3rd Party Buyer

  38. III. Prepayment (cont.) • Force Majeure • Generally excuses both parties from delivery and/or receipt obligations to the extent and for the duration of the Force Majeure event. • Buyer’s prepayment to Seller creates risk to Buyer if Force Majeure event subsequently excuses: • Seller from delivering the commodity; or • Buyer from receiving the commodity

  39. III. Prepayment (cont.) • Force Majeure (cont.) • General Rule: • If either Seller or Buyer declares Force Majeure and Buyer has prepaid Seller, then Seller returns Buyer’s entire prepayment for the period affected by Force Majeure. • If Seller claims Force Majeure and is unable to deliver the commodity to Buyer, then Buyer should get its prepayment back because it did not receive the commodity. • If Buyer claims Force Majeure and is unable to receive the commodity from Seller, Buyer should get its prepayment back because it is excused.

  40. IV. Master Netting Agreements • Two counterparties sign a Master Netting Agreement to net transactions between them and possibly those between affiliates • 3 Aspects of Master Netting Agreements: • Netting of payments • Netting of exposure • Setoff upon bankruptcy

  41. IV. Master Netting Agreements (cont.) • From a credit risk perspective, a Master Netting Agreement should have all three aspects: • ISDA Energy Agreement Bridge: Not a true Master Netting Agreement, rather a cross default tool • EEI Master Netting Agreement: Includes all three Master Netting Agreement features

  42. IV. Master Netting Agreements (cont.) • Benefits of Master Netting Agreements • Efficient use of collateral capital • Enterprise-wide netting and setoff if affiliates are included • Uniform credit terms enterprise-wide with a counterparty and all of its affiliates

  43. IV. Master Netting Agreements (cont.) • Disadvantages of Master Netting Agreements • Unwieldy • Can be complex • Expensive • Time-consuming to negotiate • Ex. EEI Master Netting Agreement • Enforceability • Cross-affiliate Master Netting Agreements have been difficult to enforce in bankruptcy

  44. IV. Master Netting Agreements (cont.) • Bankruptcy courts are hostile toward cross-affiliate Master Netting Agreements because they undermine the core principal that every unsecured creditor is treated identically • Limited case law • Enron v. Reliant indicated cross-affiliate MNA was unenforceable unless all involved affiliates sign and agree to joint and several liability • Effectively destroys multiple affiliate Master Netting Agreements

  45. V. Master Agreement with Annexes • Use a Master Agreement with common terms and various annexes specific to each product • EEI: Less widely used • ISDA: Increasingly popular

  46. V. Master Agreement with Annexes (cont.) • Advantages • Net exposure across products: Leads to more efficient collateral deployment • Single-agreement setoff treatment in bankruptcy • Avoids negotiating sticky issues that slow down negotiations more than once • Ex. Credit terms, Events of Default • Once Master Agreement is negotiated, annexes are usually very easy to add

  47. V. Master Agreement with Annexes (cont.) • Disadvantages • Master Agreement with annexes can take longer to negotiate than individual single-product Master Agreement • Gap risk between product-specific annexes to Master Agreement and single-product Master Agreement • Ex. ISDA Gas Annex v. NAESB

  48. VI. Credit Default Swaps • Buyer purchases credit protection from Seller relating to the obligation of some other entity (a “Reference Obligation”) • Buyer does NOT have to have any interest in the Reference Obligation • Buyer pays Seller a periodic fee for such protection

  49. VI. Credit Default Swaps • If a “Credit Event” occurs with respect to the Reference Obligation, Seller pays Buyer the difference between: • The face value of the Reference Obligation; and • The current market value of the Reference Obligation. • Commonly documented through the ISDA

  50. VI. Credit Default Swaps • Purpose of CDS Transactions • Increase or decrease credit exposure without the need for transferring assets or obligations • Seller in a CDS Transaction immediately increases its credit exposure without having to outlay any cash • Buyer in a CDS Transaction immediately decreases its credit exposure without having to dispose of any outstanding obligations • Ability to manage exposure makes CDS Transactions popular with banks and hedge funds