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)
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
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
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)
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 Triangular Rectangular
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 $50,000 Power $40,000 $90,000
Party B owes to Party A and Party A Affiliate:
MMBtu $25,000 Power $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 A Affiliate
Party B Affiliate
Power $40,000
Power $5,000
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, $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 A Affiliate
Party B Affiliate
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 $50,000 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

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. 22

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. 23

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. 24

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? 25

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). 26

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. 27

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. 28

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. 29

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. 30

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? 31

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 32

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. 33

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? 34

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. 35

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. 36

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. 37

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. 38

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 39

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. 40

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. 41

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. 42

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. 43

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. 44

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). 45

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.
MTA and RA
Delivery Amount:
Rounded To:
Required to Post:
$0 / $100,000
$35,000
$100,000
$0 / $1
$100,000 / $1 $0
$100,000 / $100,000 46

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 47

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. 48

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? 49

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. 50

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

52. 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.

53. Downgrade Event
Downgrade Event - The credit rating of a party or its Credit Support Provider falls below a stated credit rating threshold.
Remedies – Usually either termination of the ISDA or additional collateral.
Varies depending on the risk tolerance of the non-downgraded party.

54. 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

55. 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.

56. AT AND AFTER TERMINATION
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

57. Guaranties When are Guaranties used? A party has:
Little or no creditworthiness;
Limited liquid collateral; and
An affiliate with creditworthiness

58. 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

59. 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

60. 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

61. 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.

62. 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

63. Letters of Credit Common Limitations Imposed by Issuer:
Maximum number of letters of credit
Maximum amount outstanding
Approval of beneficiary
Approval of form

64. 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

65. 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

66. Letters of Credit Advantages: Disadvantages: 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

67. 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

68. 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.

69. 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

70. First Liens 3 Types of First Lien Credit Structures
Replacement Structure
Threshold Structure
Tail Risk Structure

71. 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

72. 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

73. 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.

74. 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

75. 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

76. 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

77. 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.

78. 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

79. 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

80. 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

81. 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

82. 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?

83. 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?

84. First Liens First Lien Terms in the ISDA (cont.):
Representations, Warranties & Covenants
Debtor’s authorization to provide the First Lien under the Credit Agreement
Compliance with representations in the Credit Agreement
Transfer and Assignment
Align ISDA with Credit Agreement
Ex: Can the ISDA be assigned or encumbered?

85. Conclusion
While the ISDA provides various “standard” credit provisions, credit risk must be tailored to each transaction.
Credit risk is not absolute, but exists on a continuum.
Different points on the continuum require different risk mitigants

86. Conclusion Risk levels are influenced by many factors:
LOW
HIGH
Next-Day Index Gas Sale
Long-Term Tolling Arrangement
Guaranty?
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

87. Conclusion The key is to identify:
RISK
LOW
HIGH
Next-Day Index Gas Sale
Long-Term Tolling Arrangement
Guaranty?
First Lien or Margining?
Letter of Credit?
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.

88. CREDIT RISK MITIGATION
Conclusion
First Lien
COST & TIME
Guaranty
Low
High
CREDIT RISK MITIGATION

89. QUESTIONS? Kevin M. Page kpage@jw.com (713) 752-4227
Jackson Walker L.L.P.
1401 McKinney, Suite 1900
Houston, Texas 77010