1 alternative collateral risk mitigation craig r. enochs jackson walker l.l.p. 1401 mckinney, suite...

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ALTERNATIVE COLLATERAL RISK MITIGATION

CRAIG R. ENOCHSJackson Walker L.L.P.

1401 McKinney, Suite 1900Houston, Texas 77010

JOHN LIGHTBOURNNextEra Energy Resources

700 Universe Blvd.Juno Beach, Florida 33408

International Energy Credit Association85th Annual Fall Conference

October 11-14, 2009Orlando, Florida

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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

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Credit Risk (cont.)

Risk levels can be influenced by many factors, including: 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?

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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

RISKLOW HIGH

Next-Day Index Gas Sale Long-Term Tolling Arrangement

Guaranty? First Lien or Margining?Letter of Credit?

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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

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Credit Risk (cont.)

COST &

TIME

CREDIT RISK MITIGATION

Low High

Guaranty

First Lien

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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

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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

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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

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I. 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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I. Guaranties (cont.) When are Guaranties used?

A party has: Little or no creditworthiness;

Limited liquid collateral; and

An affiliate with creditworthiness

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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

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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

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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

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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

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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

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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

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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

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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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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

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III. Prepayment

Buyer pays Seller before delivery

Net present value of sales price

Often preferred when dealing with non-creditworthy counterparties

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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

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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

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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

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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

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Fixed v. Variable Prepayment: Calculation and periodic adjustments

Variable price and/or variable quantity

When using an index price, should have market disruption provisions

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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

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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.

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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.

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Seller

Seller Fails to Deliver and Buyer Covers at $12/MMBtu:

Buyer

(i) $10/MMBtu Prepayment

3rd Party Seller

(ii) Gas(ii) $12/MMBtu

(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

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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.

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Seller

Seller Fails to Deliver and Buyer Covers at $5/MMBtu:

Buyer


3rd Party Seller

(ii) Gas(ii) $5/MMBtu

(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


• $10/MMBtu original prepayment

• Buyer keeps $5/MMBtu cost savings

resulting from Seller’s breach

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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.

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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.

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Seller

Buyer Fails to Receive and Seller Covers at $7/MMBtu:

Buyer


3rd Party Buyer

(ii) Gas (ii) $7/MMBtu

(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


• $10/MMBtu original prepayment, MINUS

• $3/MMBtu difference between $10

contract price and $7 resale price

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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.

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Seller

Buyer Fails to Receive and Seller Covers at $12/MMBtu:

Buyer


3rd Party Buyer

(ii) Gas (ii) $12/MMBtu

(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


• $10/MMBtu original prepayment

• Seller keeps $12/MMBtu cover payment,

including $2/MMBtu profit

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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

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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.

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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:

1. Netting of payments

2. Netting of exposure

3. Setoff upon bankruptcy

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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VI. Credit Default Swaps (cont.) Regulation:

CDS transactions generally exempt from CFTC and SEC regulation

Exempt from CFTC regulation because: Not executed on a Trading Facility (Over-the-Counter)

Entered into between Eligible Contract Participants

Exempt from certain SEC regulations because: Constitutes a “Security-Based Swap Agreement”, which is

expressly excluded from the definition of “Security” in the Securities Act and Exchange Act.

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VI. Credit Default Swaps (cont.)

CDS Transactions v. Insurance Contracts Material interest in underlying obligation

Insurance contract requires “insurable interest”

Buyer of CDS protection does not need to show any interest in the Reference Obligation

Proof of loss Insurance contract requires insured to show “proof of loss”

before amounts are paid under the policy

Seller pays Buyer amounts owed under CDS Transaction whether or not Buyer has actually incurred any loss related to the Reference Obligation.

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CDS Transactions v. Insurance Contracts (cont.) Payment of Premiums

Insurance contracts: Premiums paid on monthly basis, and rates adjusted by insurer on annual basis

CDS Transactions: Buyer pays CDS fee on a quarterly basis, and fee remains constant throughout the term of the deal.

Termination Insurance contract: Generally insured can terminate at will

CDS Transaction: Set term is defined in the Confirmation, so Buyer cannot unilaterally terminate. If Buyer fails to pay CDS fee, then Seller may declare Event of Default under the agreement

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Advantages: Seller’s creditworthiness is substituted for the

creditworthiness of the party whose obligations are secured by the CDS Transaction

Risks: Seller may become less creditworthy over the term of a

CDS Transaction

Seller may fail to pay CDS obligations upon the occurrence of a Credit Event Buyer may be exposed if it is not holding some form of

collateral or security from Seller

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VII. 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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VII. First Liens

General Overview 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 increases the value of the plant by mitigating the risk that debtor will not be able to find a purchaser for the plant’s output

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VII. 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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VII. First Liens (cont.)

3 Types of First Lien Credit Structures Replacement Structure

Threshold Structure

Tail Risk Structure

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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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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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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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VII. First Liens (cont.) 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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VII. First Liens (cont.) 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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VII. First Liens (cont.) 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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VII. First Liens (cont.) 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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VII. First Liens (cont.) 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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VII. First Liens (cont.) 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 ultra conservative risk limits and parameters in the transactions secured by the first lien Impacts ability to trade with hedge counterparty

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VII. First Liens (cont.) 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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VII. First Liens (cont.) 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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VII. First Liens (cont.) Additional Considerations with First Liens

(cont.) 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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VII. First Liens (cont.) First Lien Terms in Trading Agreements:

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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VII. First Liens (cont.) First Lien Terms in Trading Agreements

(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 Trading Agreement with Credit Agreement

Ex: Can the trading agreement be assigned or encumbered?

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VIII. Joint & Several LiabilityAgreement

J&S Liability Agreement: Affiliate counterparties agree to be jointly and

severally liable for the payment obligations of the other under their respective trading agreements

All parties agree to net credit exposures

When Used: One party trades with two or more affiliated

counterparties under separate trading agreements Structure creates a natural offset of payment and credit

obligations under all agreements

Well suited for structured transactions

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VIII. Joint & Several LiabilityAgreement (cont.)

Example: Party A owns a power generation facility

Party A purchases gas from Party B Gas under a NAESB, and sells its electricity to Party B Power under an EEI

Party A, Party B Gas and Party B Power could enter into J&S Liability Agreement so that:

Party B Gas and Party B Power would be J&S liable for each other’s payment obligations to Party A under the NAESB and EEI

The Parties could net any credit exposures together to limit collateral obligations

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VIII. Joint & Several LiabilityAgreement (cont.)

How Different than a Master Netting Agreement? Expressly creates joint and several liability between

affiliated parties MNA often provides for netting and set off across

transactions with affiliates, but does not create J&S liability for payment among such affiliates

J&S Liability can be limited only to obligations under a single trading agreement MNAs generally involve multiple agreements among multiple

counterparties and affiliates

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QUESTIONS?

CRAIG R. ENOCHSJackson Walker L.L.P.

1401 McKinney, Suite 1900Houston, Texas 77010

JOHN LIGHTBOURNNextEra Energy Resources

700 Universe Blvd.Juno Beach, Florida 33408